Working capital is an important business metric since the calculation determines a company’s ability to pay off current debts within a year.
Simply put, working capital is the money a business has to run all of its operating activities for the coming year.
But before explaining working capital in more detail, it is important to understand current assets and current liabilities, because these two accounting terms are the main components used in the calculation of working capital.
- Current assets: Current assets are all assets that are expected to be used by the end of the year. Current assets include cash, bank accounts, marketable securities, accounts receivable, inventory and supplies.
- Current liabilities: Current liabilities are the liabilities of the business that are expected to be paid by the end of the year. Current liabilities include accounts payable for goods and services purchased, rent, utilities and notes payable that are due within the year.
If you want to take a long-term view of financial health, you can also calculate working capital because working capital focuses on long-term assets and liabilities.
Presentation: what is working capital in accounting?
Working capital is the money your business currently has available for day-to-day operations. Working capital is also a good indicator of overall financial health since it involves all of the following activities:
- Revenue collection: The amount of revenue your business receives is reflected in your working capital. How efficiently your revenue is collected, as well as how your revenue is recognized, is also reflected in your working capital. Slow revenue collection can have a big impact on cash flow, with less cash available to pay day-to-day bills.
- Inventory management: Although seemingly simple, inventory management can be a complex matter. Excessive inventory can leave you with less cash, which has a big impact on your bottom line, as your business ultimately ends up with a warehouse full of products that can’t be sold. Under-ordering inventory can be just as detrimental, with the potential for lost sales as customers go elsewhere to buy products you don’t currently have in stock.
- Accounts payable: Accounts payable reflects most of your short-term debt, unless you also have short-term bills payable. Whether you’re creating financial projections for the next five years or entering numbers for next year’s budget, your accounts payable totals are a good indicator of your current cost of doing business.
Working capital vs net working capital: is there a difference?
The only difference between working capital and net working capital is how they are reported, as net working capital usually refers to a total, while working capital is reported as a ratio.
How to calculate working capital
The formula for net working capital is:
Current assets – Current liabilities = Net working capital
Using this formula will help you arrive at your working capital total. For example, if your current assets total $125,000 and your current liabilities total $95,000, your calculation would be:
$125,000 – $95,000 = $30,000 net working capital
To calculate working capital as an accounting ratio, you can use the following formula:
Current assets ÷ Current liabilities = Working capital ratio
Using the same numbers as above, your calculation would look like this:
$125,000 ÷ $95,000 = 1.32 Working capital ratio
This means that for every dollar of current liabilities you have, you have $1.32 of current assets available to pay them off.
The working capital ratio formula is similar to the quick ratio, but includes inventory, which the quick ratio excludes. The working capital ratio measures a company’s overall liquidity, including its ability to repay any current liabilities with current assets.
What does working capital tell you about your business?
Although working capital is an easy calculation, the number can tell you a lot about the health of your business. For example, a working capital ratio of less than one indicates that your business is facing severe cash flow problems and does not have enough current assets to pay short-term debts.
It can also signal to potential investors and financial institutions that your business is stable and operating well within its means to pay any future liabilities. Here are a few other things working capital can tell you about your business:
Whether you need to make changes
As a business owner, you’re responsible for everything from paying rent on time to ensuring your employees’ paychecks don’t bounce.
Your working capital gives you the information you need to know if you will be able to meet all your financial obligations for the coming year or if you need to make any changes.
The overall liquidity of your business
Although the numbers in your cash flow statement and profit and loss statement give you an indication of how your business is performing, neither of these reports can provide you with a good indicator of your business’s financial stability for the future. ‘next year.
The working capital ratio gives you a good overview of your company’s total liquidity for the coming year.
The health of your business
Measuring working capital is especially important for potential investors and financial institutions you may be considering doing business with. The deceptively simple working capital number or ratio can provide a lot of information about your business, especially how it will perform throughout the current fiscal year.
Sometimes referred to as negative working capital, a working capital ratio below 1 means your business will be viewed as a risk by investors and financial institutions. It also means you run the risk of not being able to pay your bills on time.
Imagine trying to manage your household without knowing how much money you received and without knowing how much money you need to pay your bills. Calculating your business working capital provides you with these answers.
It can also identify potential issues before they become a major impediment to the health of your business.
No. Whether you choose to calculate working capital as a ratio or prefer to calculate net working capital, the formula is simple:
- In proportion : take your current assets and divide by your current liabilities
- In number : take your current assets and subtract your current liabilities
The average working capital ratio is 1; which means that for every $1 of current liabilities, you have $1 of current assets. A working capital ratio between 1.5 and 2 indicates strong financial stability and generally indicates that assets are being used properly.
A working capital ratio below 1 suggests potential liquidity issues, while a working capital ratio above 3 suggests that assets are not being used properly.
All businesses should know what their working capital is
Regardless of the part of your business life cycle, calculating your working capital is important. Although it is possible to calculate this ratio manually, the best way to calculate your working capital is to use accounting software.
If you’re looking to automate your business or are just looking for something new, be sure to check out The Ascent’s accounting software reviews.