Working capital is a simple formula that provides deep insight into the short-term financial health of your business. By calculating your business working capital, you can better understand your business’s liquidity, operational efficiency, and resilience. You can also get insight into how and when to grow.
Ready to calculate your working capital? Get out your calculators and let’s go.
Run the numbers
Working capital is a comparison between a company’s current assets and its current liabilities over the next year. Basically, it asks: how much do you have that can be converted into cash versus how much do you owe? It is useful to know this, because there may be times when a company needs to sell assets or spend its cash reserves. Working capital numbers can help you gauge your business’ resilience in the face of a downturn. On the plus side, calculating your working capital can tell you when it’s a good time to spend money on your business.
To calculate working capital, first add up 12 months of your business assets. These may include:
- Investments you can convert to cash
- Accounts receivable (money owed to you)
- Materials and inventory
- Prepaid expenses
Next, add up 12 months of business liabilities, such as:
- Accounts payable (payments due)
- Loan payments (only what is due within the next 12 months)
- Other unpaid expenses
To calculate the amount of assets after liabilities in dollars (net working capital), simply subtract liabilities from assets.
Net working capital
Assets-Liabilities=Net working capital
To see the strength of your ability to get cash quickly by selling materials or inventory versus impending expenses (working capital ratio), divide your assets by your liabilities.
Working capital ratio
Assets/Liabilities=Working capital ratio
See it in action
Your working capital ratio helps you get an overview of how your business is doing. For example, Company A has $2 million in assets and $1.95 million in liabilities, which equals net working capital of $50,000. Company B, with $200,000 in assets and $150,000 in liabilities, also has net working capital of $50,000. But one company is in a much riskier position than the other.
Company A has a working capital ratio of 1.03 (2 million divided by 1.95 million), which means that if no revenue is generated in the next year, its assets will barely cover its passive. However, Company B has a working capital ratio of 1.5 ($200,000 divided by $150,000), which means it is much more likely to face a sudden drop in revenue.
Determining Which Equation Is Most Useful
Both working capital formulas are useful. Which one you use depends on what you need to know.
Net working capital lets you know the dollars you have available to work with. If you’re watching your cash flow closely and want to make sure you have the capital you need to keep operating six months from now, net working capital can help you see how much your cash balance might drop. On the other hand, if your business is profitable and you’re accumulating cash, knowing your net working capital can help you decide if it’s time to make a big purchase of equipment that can help your business grow.
Find your sweet spot
A low working capital ratio may indicate a problem, but how low is it?
Each company will have its own sweet spot based on the particularities of its assets and liabilities. Generally speaking, a working capital ratio near or below 1.0 could indicate higher risk. Why? Remember that assets include almost everything of value in your business, not just money. If a decrease in the supply of cash forces you to sell assets you need for future sales, you’ve made money, but you may have lost earning potential. The longer a company has to draw on its assets, the more likely it is that it will not have enough assets to continue generating revenue.
At the other end of the scale, a working capital ratio of 2.0 means the business has double the capital to cover next year’s expenses, which is very good but could signal another type of problem.
A business that hoards money misses opportunities to invest money in expenses that can increase its revenue. Plus, the company could pay higher taxes on all that stagnant money. Other companies may have a high working capital ratio because they have invested heavily in inventory. On the one hand, inventory is good because it means you have something to sell, but too much inventory could put a strain on your cash flow. A cash-strapped business may need to sell inventory faster, which may mean offering deep discounts just to get cash out the door.
Want to grow your working capital? We have an article with some tips. If you are unsure what working capital means for your business, it may be helpful to speak to a investment banker to discuss products that can help you get the most out of your working capital.
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