What is the Working Capital Formula?
The working capital formula is:
Working capital = Current Assets – Current Liabilities
The working capital formula tells you the short-term liquid assets available after short-term liabilities have been paid off. It measures a company’s short-term liquidity. It is important for financial analysis, financial modeling, and managing cash flow.
Working capital represents a company’s ability to pay its current liabilities with its current assets. It is an important measure of financial health. Creditors can use the working capital formula to measure a company’s ability to pay off its debts within a year. Attention should be paid to the proper category of assets and liabilities on a corporate balance sheet. Working capital is an additional tool for determining the overall health of a firm and its ability to meet short-term commitments.
Example calculation with the working capital formula
A company can increase its working capital by selling more of its products. If the price per unit of the product is $1000 and the cost per unit in inventory is $600, then the company’s working capital will increase by $400 for every unit sold, because either cash or accounts receivable will increase. Comparing the working capital of a company against its competitors in the same industry can indicate its competitive position. If Company A has a working capital of $40,000, while Companies B and C have $15,000 and $10,000, respectively, then Company A can spend more money to grow its business faster than its two competitors. (Source:corporatefinanceinstitute.com)
Components of Working Capital Formula
Current Assets
Current assets are the things a company currently owns—both tangible and intangible. Also, they must be easily turned into cash within one year or one business cycle, whichever is less. Categories include checking and savings accounts, liquid marketable securities such as stocks, bonds, mutual funds, and ETFs, money market accounts, cash and cash equivalents, accounts receivable, inventory, and other shorter-term prepaid expenses. Other examples include current assets of discontinued operations and interest payable. Current assets do not include long-term investments such as real estate or collectibles.
Current Liabilities
Liabilities are considered current when they are debts and expenses the firm expects to pay within a year or one business cycle, whichever is less. This typically includes all the normal costs of running the business. For example, rent, utilities, materials and supplies, interest or principal payments on debt, accounts payable, accrued liabilities, and accrued income taxes. Other current liabilities include dividends payable, capital leases due within a year, and long-term debt that comes due during the current business cycle.
What is Working Capital?
Working capital is the difference between a company’s current assets and current liabilities. It is a financial measure, which calculates whether a company has enough liquid assets to pay its bills that will be due within a year. When a company has excess current assets, that amount can then be used to spend on its day-to-day operations.
- Current assets, such as cash and equivalents, inventory, accounts receivable, and marketable securities, are resources a company owns that can be used up or converted into cash within a year.
- Current liabilities are the amount of money a company owes, such as accounts payable, short-term loans, and accrued expenses, that are due for payment within a year.
What is Net Working Capital?
Working Capital and Net Working Capital are often used interchangeably. However, there are subtle differences between the two terms. Net Working Capital (NWC) is the difference between a company’s current assets and current liabilities on its balance sheet. It is a measure of a company’s liquidity and its ability to meet short-term obligations, as well as fund operations of the business. The ideal position is to have more current assets than current liabilities, and thus have a positive net working capital balance. Different approaches to calculating NWC may exclude cash and debt (current portion only), or only include accounts receivable, inventory, and accounts payable.
Net Working Capital Formula
There are a few different methods for calculating net working capital, depending on what an analyst wants to include or exclude from the value.
- Net Working Capital = Current Assets – Current Liabilities
- Net Working Capital = Current Assets (less cash) – Current Liabilities (less debt)
- NWC = Accounts Receivable + Inventory – Accounts Payable
The first formula is the broadest as it includes all accounts. The second formula is more narrow, and the last formula is the most narrow as it only includes three accounts.
What Does Working Capital Ratio Mean?
The working capital ratio is another way to compare assets and liabilities. This ratio gives an idea as to whether or not a company has short-term assets to cover the short-term debt. Finding the net working capital ratio is simple. You divide the numbers instead of subtracting them to get a ratio. The Working Capital Ratio Formula is as follows:
Working Capital Ratio = (Current Assets) / (Current Liabilities)
A healthy business should have extra capacity to pay off its current liabilities with current assets. A higher ratio above 1 means a company’s assets can be converted into cash at a faster rate. The higher the ratio, the more likely a company can pay off its short-term liabilities and debt. A higher ratio also means the company can easily fund its day-to-day operations. Extra working capital means that a company may not have to take on debt to fund the growth of its business. However, a company with a ratio of less than 1 is considered risky by investors and creditors. It indicates that the company may not be able to cover its debt if needed. A current ratio of less than 1 is known as negative working capital.
Positive vs Negative Working Capital
Positive working capital is considered a good sign of the short-term financial health of a company. It means there are enough liquid assets to pay off short-term bills and finance growth internally. Without excess working capital, a company may have to borrow additional funds from a bank to meet current obligations.
Negative working capital can indicate that assets aren’t being used effectively. A company may even face a liquidity crisis. Companies with sizeable fixed asset investments may still face financial challenges if liabilities come due unexpectedly. This may lead to more borrowing or late payments to creditors and suppliers. The result would be a lower corporate credit rating for the company.
When negative working capital is ok
Depending on the type of business, companies can have negative working capital and still do well. Examples are grocery stores or fast-food chains that can generate cash very quickly. This is due to high inventory turnover rates and by receiving payment from customers in a matter of a few days. These companies need little working capital to be kept on hand, as they can generate cash very quickly. Often, products that are bought from suppliers are immediately sold to customers before the company has to pay the vendor or supplier.
In contrast, capital-intensive companies that manufacture heavy equipment and machinery usually can’t raise cash quickly. Often, they sell their products on a long-term payment basis. If they can’t sell fast enough, the cash won’t be available immediately during tough financial times. Having adequate working capital is essential for capital intensive companies with slower cash flow.
How to Improve Net Working Capital
Once you know how to use the working capital formula, it’s possible to try and improve it. By making some simple improvements, net working capital is highly changeable. Here are steps you can take to achieve positive net working capital:
Steps you can take
- Turn Inventory Over Faster – Inventory is considered an asset in the working capital formula. But, it’s not as liquid as cash or other assets. In other words, cash is tied up in inventory. If you’re storing inventory for long periods, you may find yourself with dwindling cash. The solution is to turn your inventory over faster. You can address this by not over-ordering, focusing on quicker turnover, and by re-evaluating stock items that sell slowly. Maybe it’s even worthwhile to return unused inventory to suppliers in exchange for a restocking fee.
- Extend Accounts Payable Terms – Negotiate with vendors and suppliers for longer accounts payable payment terms. Any extension will help keep cash in your pocket longer.
- Convert Long-Term Assets – Long-term assets present the same problem as inventory. They tie up cash for extended periods for things like equipment and buildings. If you’re not fully utilizing long-term assets, you may want to consider selling them. This will generate cash as well as increase your cash flow. If you have extra office space, sell or rent part of it. The same goes for machinery you no longer use.
- Refinance Debt – Refinancing will allow you to increase working capital by turning short-term loans to long-term debt. Short term loans are loans that must be repaid in one year or less. Therefore, refinancing is a good option for those with a history of on-time payments. It lengthens payment schedules, gives you a lower monthly payment, and yields more cash for working capital.
- Accelerate Accounts Receivable – Significant amounts of cash get tied up in aging invoices and receivables. By reducing your accounts receivable period you can improve working capital. Consider trying to encourage early payment by implementing discounts. Also, aggressively pursue amounts that are legitimately past due.
Frequently Asked Questions
What is the working capital formula?
The working capital formula is Working capital = current assets – current liabilities. The working capital formula measures the short-term financial health of a business. It enables you to check if you have enough money available to meet financial obligations on a short-term basis.
What is the working capital ratio?
The working capital ratio is how many times a business can pay off its current liabilities using current assets. A ratio of less than one means the likelihood of financial difficulties! The Working capital ratio = current assets/current liabilities.
Conclusion
Working capital as a ratio is meaningful when it is compared, alongside activity ratios, the operating cycle and cash conversion cycle, over time and against a company’s peers. Taken together, managers and investors gain powerful insights into the short term liquidity and operations of a business. Each component – inventory, accounts receivable, and accounts payable is important individually. But, taken together, they comprise the operating cycle for a business. Therefore, they must be analyzed both together and individually.
As an entrepreneur, it’s essential to know how to calculate working capital. The working capital formula is not at all complicated to understand. You can immediately take advantage of this useful tool to gain insight into your company’s financial health.
Up Next: Straight Line Depreciation – Understanding the Straight Line Method
Straight line depreciation is a method of calculating depreciation and amortization. Also known as straight line basis, it is the simplest way to work out the loss of value of an asset over time. Straight line basis is calculated by dividing the difference between an asset’s cost and its expected salvage value by the number of years it is expected to be used. Using this method of depreciation, the cost of a fixed asset is reduced uniformly over the useful life of the asset. Since the depreciation expense in each period is the same, the carrying amount of the asset on the balance sheet declines in a straight line. Due to its simplicity, the straight-line method of depreciation is the most common depreciation method.
