What is working capital?
Working capital—also known as “net working capital”—is a measurement of a business’s short-term financial health. Simply put, it indicates your liquidity or ability to pay your bills. You can find it by taking your current assets and subtracting your current liabilities, both of which can be found on your balance sheet.
A positive working capital shows a business holds more cash value than its short-term debts. These businesses have enough cash to pay off their debts with some leftover to invest in the company. This shows lenders and investors that you are reliable in servicing your debts with the potential for growth.
A negative working capital shows a business owes more than the cash it currently holds. This is a red flag for both lenders and investors that would provide funding. But it should also signal to you that you need to start increasing your cash flow.
What is the formula for working capital?
The formula for working capital is:
Working Capital = Current Assets – Current Liabilities
Your current assets
You can think of your current assets as the cash you hold as well as any cash you have guaranteed coming in.
The four major types of current assets are:
• Your accounts receivable—any payments from your clients you haven’t received yet
• Your cash equivalents which include cash held in bank accounts
• The value of any inventory you hold
• The value of any marketable securities such as common stock
These values are all listed on your balance sheet (if you have one). Otherwise, begin with your bank balances to see your cash levels.
Your current liabilities
Your current liabilities are any short-term outstanding debts that you have to pay off within the next year.
**Some examples of current liabilities: **
• Your accounts payable—any outstanding payments you have for goods or services you’ve been given
• Your outstanding credit card balances
• Any outstanding wages payable
• The outstanding balance of any loans that mature within one year
• Any accrued liabilities such as income or payroll tax
To add up your liabilities, collect any unpaid invoices to find your outstanding accounts payable. You can find credit card and loan balances by logging into your online account with the provider. Refer to your payroll records for any outstanding wages or tax liabilities.
Once you have these values, finding your working capital value is a breeze. Subtract your current liabilities from your current assets and you’re done!
If your value is positive, you have more cash than short-term loans, indicating that you have a significant potential for growth through reinvesting in the firm. Alternatively, you may be able to incur more short-term debt. However, if your worth is negative, you owe more than you own, and it’s time to start searching for strategies to enhance your cash flow. Consider holding a sale to generate more money, or look into refinancing your short-term debt to something longer term.
The working capital ratio
With your current assets and current liabilities, you can also calculate the working capital ratio (or current ratio). The working capital ratio is a similar calculation and another way of showing a business’s ability to cover its debts. Instead of subtracting your current liabilities from your current assets, you will be dividing your current assets by your current liabilities:
Working Capital Ratio = Current Assets / Current Liabilities
For your current ratio, a value greater than one corresponds with positive working capital, and a value less than one corresponds with negative working capital.
The working capital cycle
Your working capital cycle is the amount of time it takes for you to convert your net working capital amount into cash. This can be found by taking the time in between when you have to pay your short-term debts and when you will receive outstanding accounts receivables.
- For example, let’s say Shawna’s Shoes has $2,500 in outstanding accounts receivables on a 60-day payment deadline and $1,000 in accounts payable due in 30 days. The net working capital value would be $1,500 ($2,500 in accounts receivables minus $1,000 in accounts payable).
- Her working capital cycle is the time in between paying her accounts payables and receiving her accounts receivables: 30 days. Her working capital cycle shows her she needs to budget for at least 30 days in between when she pays her bills and when she receives her payments.
- You’ll want to minimize your working capital cycle. To start, you can shorten your payment terms for your outstanding receivables and try to extend the time before you need to service your debt.
The basics of working capital management
To begin managing your working capital, keep track of your current assets and current obligations so that you can always determine the working capital value. When you’re tracking it, try to maintain it positive at all times. Reduce your present liabilities by paying off debt early or refinancing short-term commitments into longer durations. Perhaps you can take out a longer-term loan to cover some recent short-term accounts payables.
Then, aim to stay ahead of your working capital cycle. Consider decreasing your payment terms and increasing the amount of time you have to cover your short-term responsibilities. This will assist you in managing your cash flow and ensuring that you have as little time as possible between paying for items like your cost of living.
