Working capital is an important business metric since the calculation determines the ability of a company to pay off current debts within a year.
Simply put, working capital is the money available to a company to handle all of its operating activities for the upcoming year.
But before we explain working capital in more detail, it’s important to understand current assets and current liabilities, since these two accounting terms are the main components used in calculating working capital.
- Current assets: Current assets are any 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 company liabilities that are expected to be paid by the end of the year. Current liabilities include accounts payable items for goods and services purchased, rent, utilities, and notes payable that are due within the year.
If you wish to get a long-term view of financial health, you can also calculate operating working capital, since operating working capital focuses on long-term assets and liabilities.
Overview: What is working capital in accounting?
Working capital is money that is currently available to your business to use 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: How much revenue your business collects is reflected in your working capital. How effectively your revenue is being collected, as well as how your revenue is recognized, are also reflected in your working capital. Slow revenue collection can severely impact cash flow, with less cash available to use for paying current bills.
- Inventory management: While simple on the surface, inventory management can be a complex matter. Over-ordering inventory can leave you with less cash, severely impacting your net income, with your business ultimately ending up with a warehouse full of products that can’t be sold. Under-ordering inventory can be just as detrimental, with a potential for lost sales as customers go elsewhere to purchase products you currently don’t have in stock.
- Accounts payable: Accounts payable reflects the main portion of your current liabilities, unless you have short-term notes payable as well. Whether you’re in the process of 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’re reported, as net working capital usually refers to a total, while working capital is reported as a ratio.
How to calculate working capital
The net working capital formula is as follows:
Current Assets – Current Liabilities = Net Working Capital
Using this formula will help you arrive at your working capital total. For instance, 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
Toi calculates 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 be as follows:
$125,000 ÷ $95,000 = 1.32 Working Capital Ratio
This means that for every $1 in current liabilities you have, you have $1.32 in 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 pay off any short term liabilities with short term assets.
What does working capital tell you about your business?
Though working capital is an easy calculation, the number can tell you a lot about the health of your business. For instance, a working capital ratio of less than one indicates that your business is facing severe liquidity issues and does not have enough current assets to pay current liabilities.
It can also tell potential investors and financial institutions that your company is stable and operating well within its means to pay any upcoming liabilities. Here are a few other things that 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 the rent on time to making sure your employee’s paychecks don’t bounce.
Your working capital provides you with the information you need in order to know whether you’ll be able to fulfill all of your financial obligations for the upcoming year or need to make changes.
The overall direction of your business
While the numbers on your cash flow statement and profit and loss statement provide you with an indication of how your business is performing, neither report can provide you with a good indicator of how financially stable your business will be for the next year.
The working capital ratio provides you with a good look at the total liquidity of your business for the upcoming year.
How healthy your business is
The working capital metric is particularly important to potential investors and financial institutions that you may be looking to do business with. The deceptively simple working capital number or ratio can provide a lot of information about your business, particularly how it will fare throughout the current fiscal year.
Sometimes referred to as negative working capital, a working capital ratio of less than 1 means that your business will be considered 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 run your household without knowing how much money you had coming in and not knowing how much money you needed to pay your bills. Calculating working capital for your business provides you with those answers.
It can also pinpoint potential areas of trouble 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 the net working capital calculation, the formula is simple:
- As a ratio: take your current assets and divide by your current liabilities
- As a number: take your current assets and subtract your current liabilities
The average working capital ratio is 1; meaning that for every $1 of current liabilities, you have a $1 in current assets. A working capital ratio of between 1.5 and 2 indicates solid financial stability, and usually indicates that assets are being used properly.
A working capital ratio of less than 1 suggests potential liquidity issues, while a working ratio of more than 3 suggests that assets aren’t being utilized properly.
All businesses should know what their working capital is
No matter what part of the life cycle your business is in, calculating your working capital is important. While it’s possible to calculate this ratio manually, the best way to calculate your working capital is by using accounting software.
If you’re looking to automate your business or are just in the market for something new, be sure to check out The Ascent’s accounting software reviews.