Every small business has a certain level of working capital, but if you’re not sure what it is and how it’s calculated, we’ve got you covered. In simple terms, working capital can also be referred to as net working capital. It is the difference between a company’s short-term assets, such as cash on hand, accounts receivable/unpaid invoices from customers, and inventory of materials and finished goods, and its short-term liabilities, such as accounts payable and payables.
How to calculate working capital
Working capital is calculated by dividing total current assets by total current liabilities (including long-term and short-term liabilities). This business tool helps companies make the most of their current assets and maintain sufficient cash flow to meet their short-term goals and other obligations. A business’s working capital can also determine whether the business has enough cash to support its operations and the amount of working capital can also determine the long and short term financial health of a business.
Positive working capital means the business can pay its bills and also make investments to drive business growth. Negative working capital means that the company’s current liabilities exceed its assets and that it has more current debts than current assets.
Working capital formula
The working capital formula is simple and will always be calculated as follows:
Working capital calculation: Working capital = Current assets – Current liabilities
Current assets include cash and accounts receivable, while current liabilities include accounts payable (AP).
There are other important working capital metrics to keep in mind, including:
- Days Payable Outstanding (DPO): The average number of days the company takes to reimburse accounts payable. It measures how the company manages its AP. For example, a DPO of 30 means that the company takes 30 days to reimburse its suppliers. It is calculated as follows:
Accounts Payable X Days/Cost of Goods Sold (COGS) = DPO
- Days Sales Outstanding (DSO): The average number of days it takes customers to pay their bills, usually showing a problem with their cash flow. It is used to determine the effectiveness of a company’s credit and collection efforts to provide credit to its customers, in addition to its ability to collect from them. It is calculated as follows:
(Accounts receivable ÷ annual revenue) × Number of days in the year = DSO
- Days Inventory Outstanding (DIO): The average number of days the company holds inventory before selling it. This ratio shows how quickly a company can turn inventory into cash. The formula is:
DIO = (Average Inventory / Cost of Sales) x Number of Days in Period
- Cash Conversion Cycle (CCC): This process occurs when a business buys inventory, sells the inventory on credit as accounts receivable, and then collects the accounts receivable. The CCC can also be referred to as the “net cash cycle,” which measures the average number of days it takes for a business to purchase inventory and turn that inventory into cash.
CCC is calculated by:
DIO + DSO – DPO = CCC
Working capital ratio
The working capital ratio is a measure of the liquidity or ease of an asset to be converted into cash without changing its market price (liquid assets). The ratio indicates whether a company can pay its obligations such as debts, advances, etc. The ratio indicates whether or not your company has the capacity to pay its short-term debts with the assets available in the short term. So, whether it’s short-term or long-term debt, do your company’s current assets cover the debt?
What does working capital ratio mean?
The working capital ratio formula shows the ratio of assets to liabilities. It means how many times a company can repay its short-term debts with its current assets which is based on the working capital ratio: Working capital ratio = Current assets / Current liabilities.
Knowing the ratio is important because relying on working capital alone would make two companies with vastly different assets and liabilities seem identical. Also, a higher ratio means there is more cash available, while a lower ratio means cash is much tighter and indicates a cash flow problem.
Working capital vs net working capital
You may find that “working capital” and “net working capital” are synonymous. The two terms identify the differences between all current assets and all current liabilities.
However, although they are often used interchangeably, some analysts use this formula for “net working capital”:
Net working capital = current assets (less cash) – current liabilities (less debt)
An additional definition of net working capital excludes most types of assets and focuses only on accounts receivable, accounts payable, and inventory.
Net working capital = accounts receivable + inventory – accounts payable
Items included in working capital
There are three main components of working capital which include:
- Accounts Payable (AP)
- Accounts Receivable (AR)
- Current assets (stocks, cash, cash equivalents, etc.)
Cash, accounts receivable, and inventory are usually found in your company’s current assets column. AP is considered a passive.
How working capital affects cash flow
Cash flow represents each amount of money flowing in and out of your business. Working capital is more a company’s balance sheet than its financial statements. Working capital and cash flow work together to provide a more complete picture of your business’s operating finances – showing micro and macro level financial analysis.
Cash flow may include:
Any change in a company’s working capital is reflected in its cash flow statement. Here is an example of working capital that shows its effect on cash flow:
If a business received cash from a short-term debt such as a line of credit or a short-term loan that must be repaid within 60 to 90 days, the business would see an increase in the cash flow statement. However, the working capital would show no increase because the loan money would be classified as a current asset or as cash. The short-term loan or debt would then be a current liability.
Another example would be:
Your business buys a brick and mortar. As a result, your cash flow would immediately decrease since you used cash (current assets) to make the purchase. However, your current liability would not change as it is longer term debt.
The importance of understanding your working capital
Simply put, your business needs and relies heavily on working capital to operate. Understanding your working capital helps in three main areas:
- Know the orientation of the company’s investments
- Identify the liquidity of company assets
- Influencing negotiations with suppliers and vendors
What is working capital management?
The purpose of working capital management is to make sure you’re on track with your business’ cash flow. When you have insufficient working capital, it causes a domino effect such as the inability to meet obligations as they come due and results in late payments to creditors, employees, and suppliers. Without working capital management, your business can end up with damaged credit, an unreliable supplier relationship, and employee attrition.
Besides liquidity, working capital management focuses on a company’s profitability. Working capital is not always synonymous with funds that generate a return. Therefore, the role of working capital management is to ensure that the business does not do two things:
- Overtrading: This is insufficient working capital to support the level of trading activities.
- Overcapitalization: This is an extreme level of working capital that leads to inefficiency.
Essentially, working capital management is important because it ensures that you use your company’s resources more efficiently by monitoring and then optimizing the use of current assets and liabilities. In addition to educational tools, Nav’s marketplace for finding the best financing for your business can definitely help your working capital work for you.
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