How to Calculate Working Capital: Guide, Formula, Examples

Businesses (offline and eCommerce) have two primary goals: to generate maximum profit and run an uninterrupted business operation. Achieving these two goals depends on the way the business is run.

As an entrepreneur or business owner, you need to ask yourself these questions: Has there been any progress since I started? What is the progress rate? Is my business running at a profit or loss? To answer these questions, you need to look in your books.

If you are not doing the bookkeeping basics such as keeping your records and preparing your financial statements on time, it is essential that you do them. It may sound like basic accounting but not doing it in real-time can prevent you from figuring the current financial status of your business.

You can look at your current assets in your balance sheet and be convinced that you are doing well. But once you take a look at your current liabilities, the excitement dies off.

What's the solution? Tracking your working capital.

Working capital is what helps you determine the current financial health of your business. It is what tells you if your company has enough current assets to pay out its current liabilities that are due within a year.

This article will discuss everything you need to know about working capital such as its meaning, components, formula, and real-life examples of working capital calculations.

Let’s get started.

What is Working Capital?

Working capital refers to the money used to pay for short-term loans and expenses. It is the difference between the money coming in and the money going out of a company's account. You can also define it as the difference between a company's current income and liabilities.

A positive capital is an indication of a company's financial health and its ability to reach its financial goals. Working capital is also known as equity capital, working assets, or risk capital.

Mathematically, Working Capital = Current Assets – Current Liabilities

For instance, if a company has current assets worth $150,000 and current liabilities worth $110,000, then it will have $40,000 as its working capital. You can refer to the $40,000 as the Net Working Capital (NWC).

Working capital helps a company measure its ability to pay up its short-term expenses and debts within a year. For efficient business operations, you need to settle these short-term payments when due. That is the function of working capital.

A company’s working capital is integral for running its day-to-day operations. If a company has a significant working capital, it means they generate more income than they spend. Working capital funds a company's major projects and helps it remain active during financial downtimes.

Working capital can also be used to pay rents and salaries of staff including payroll taxes. If a company has a separate account to record profit savings, the savings is also the company's working capital. It can cover a broad range of operational and non-operational expenses.

For you to have an efficient and positive working capital, you need to weigh your current levels. Consider your immediate needs and devise ways to increase the cash coming into the company. A close check on the income and expenditure can provide the needed insights on how to your business's financial health.

Also, significant working capital allows a company to invest and expand the business. Managing your working capital involves liquidity management, accounts receivable management, inventory management, accounts payable management, and short-term debt management.

Components of Working Capital

Working capital has two major components: the current assets and the current liabilities. You can extract your current assets and liabilities from your balance sheet, they fall on opposites of the sheet.

Current Assets

One side of a company's balance sheet contains the current assets. Assets are everything a company owns, either partly or outrightly. They can either be in cash or materials, but they can all be converted to currency within a year. A company's official van for transportation is also part of the assets.

Current assets are the cash and resources that can be converted to cash that the company owns and can easily use to run its operations within a year.

The current assets column shows the income coming into the company's account. An asset is regarded as current if it can be converted to cash within a short time (usually not more than a year). For emphasis, current assets can be in the form of cash, inventories, and trade receivables.

• Cash is an essential component of current assets. Current assets are always converted to cash before they are calculated or evaluated.
• Inventory is another component of assets that refers to goods the company produces and has for sale. There are three types of inventory: inventory of finished foods, inventory of raw materials, and inventory of work-in-progress. Businesses use inventory management software to manage their inventory.
• Trade receivables refer to the amount owed by a company's customer to a company for the sales of goods or services on credits.

Current assets do not include long-term investments or properties (e.g., lands, real estates, etc.) that cannot be liquidated quickly.

Current Liabilities

The other side of a business's balance sheet contains the liabilities. Current liabilities are the expenses a company is expected to pay up within a specific timeframe (consistently a year). It is the cost of running the day-to-day activities of a business.

Current liabilities include loans, debts, trade payables, dividends, financial obligations, and more. Whatever you have on the current liabilities column will be paid using the assets.

Costs like utility bills, raw materials, and rents are also under the current liabilities column. Your current assets must be valuable to pay off current liabilities for you (an entrepreneur) to have a smooth run.

Current liabilities can be split into six categories: utility bills, trade payable, lease/rents, loans, salaries/wages, and dividends payables.

• Utility bills are bills paid to keep water, electricity, and other utilities constantly running. These are vital bills to pay for a company to keep running. They fall under the company's liabilities.
• Trade payable refers to the amount of money a company pays to its suppliers for the supply of raw materials and other goods. It also includes the services a company consumes in the course of doing business.
• Lease or rents are the payments made for the real estate space occupied by the company. If the company is on leased land, there are specific payments to be made periodically. These payments are noted under the current liabilities.
• Loans here refer to short-term loans that are to be paid within 12 months. You can acquire loans during the financial downtimes of your business. The company maximizes the loans to get more assets and pay back the loan in no time.
• Salaries or wages are the payments for the human labor contributing to the operation of the business. Some businesses pay the workers monthly while some others pay hourly. These payments are also grouped under current liabilities.
• Dividend payable is the amount of money a company distributes to its shareholders. However, it might not be in cash form for some time, but it is noted under the company's current liabilities column in the balance sheet.

Every substance that leaves the company's financial pocket (either in cash or not) is considered a liability.

Working Capital Formula

The standard working capital formula used is to find the difference between your current assets and current liabilities.

Working Capital = Current Assets – Current Liabilities

You can use this simple working capital formula to gain better insights into the state of your business's financial health. If you have a large positive number, it means you have a lot coming in rather than going out.

In the opposite fashion, if you have a small or negative number, it means there is little or nothing left as profit from your business transactions. A negative result is a sign that the company is running at a loss and in financial distress. If the situation is not rescued, it can cause the company to become unable to operate and go bankrupt.

Most times, numbers are not enough to describe the profits of a business. You can have a decrease in the value of your assets and still handle your liabilities.

A more valuable way of determining the working capital is to use the simple net working capital ratio. It is best to calculate the ratio of the current assets to the current liabilities. Representing these numbers in proportions gives you a better knowledge of the financial status. A ratio above one shows that the current assets are more than the current liabilities.

Net Working Capital Ratio = Current Assets / Current Liabilities

With this net working capital ratio, the higher the ratio, the higher the chances of settling your liabilities without affecting the core operations. You can use the net working capital ratio to determine how well your company has been performing. Is it moving up or down? Is it consistent?

There is another formula for calculating your net working capital. It depends on the variable you have present to use for the calculation. For this formula, you need information about your accounts receivable, inventory, and accounts payable.

Working Capital = Accounts Receivable + Inventory – Accounts Payable

This formula involves three accounts, unlike the former one. You need to add the amount your customers owe you due to credit sales to the cost of your properties in the company. Then, you subtract the account payable from the addition.

Account payable is the amount a company owes its suppliers. It is always in the liability column.

You don't need to know the value of the total assets and liabilities with this formula. Some business analysts prefer this model.

There is another working capital formula that takes into factor more variables than the previous two methods. It is suitable for businesses that deal with many current assets and current liabilities variables.

Working Capital = (Cash + Accounts Receivable + Inventory) – (Accounts Payable + Accrued Expenses)

Working Capital Calculation Example

Here are some examples of working capital calculations using the different working capital formulas.

Example 1

An online store that specializes in selling phone accessories from iPhone and Android devices wants to calculate its working capital. Under current assets in its balance sheet, it has cash of $50,000, inventory worth $35,000, account receivables of $30,000, taking its total current assets tally to $115,000.

Under current liabilities in its balance sheet, it has short-term expenses of $15,000, accounts payable of $20,000, and short-term debts of $45,000, taking its total current liabilities to $80,000.

We can calculate your working capital by subtracting the total current liabilities from the total current assets.

Working Capital = Current Assets – Current Liabilities

Working Capital = $115,000 – $80,000

Working Capital = $35,000

The online store has working capital of $35,000. From the calculation, you can see that the current assets exceed the current liabilities by a sizable $35,000. It means that the company has a stable financial status. The online store has enough working capital to handle its current liabilities and even take on more projects.

You can also calculate the working capital ratio for this online store by dividing the current assets by the current liabilities.

Net Working Capital Ratio = Current Assets / Current Liabilities

Working Capital Ratio = $115,000 / $80,000 = 1.44 / 1 or 1.44:1

From the ratio gotten, the current assets are more than one, which means the online store selling phone accessories is in a good financial state.

Example 2

A furniture dealer operating in Texas has the following current assets and current liabilities in its balance sheet. It has accounts receivable worth $250,000, inventory worth $300,000, and accounts payable worth $350,000. Here is how to calculate its working capital.

Working Capital = Accounts Receivable + Inventory – Accounts Payable

Working Capital = $250,000 + $300,000 – $350,000

Working Capital = $550,000 – $350,000

Working Capital = $200,000

To calculate the working capital ratio, you have to put the account receivables, inventory and accounts payable in their appropriate categories (current assets and current liabilities).

Net Working Capital Ratio = Current Assets / Current Liabilities

Accounts receivable and inventory are examples of current assets while accounts payable is an example of current liabilities.

Net Working Capital Ratio = Accounts Receivable + Inventory / Accounts Payable

Net Working Capital Ratio = $250,000 + $300,000 / $350,000

Net Working Capital Ratio = $550,000 / $350,000

Net Working Capital Ratio = 1.57

The furniture dealer has a healthy net working capital ratio which indicates the business is operating efficiently.

Example 3

An eCommerce clothing company wants to find out its working capital. On its balance sheet (the asset side), it has $100,000 in cash available, $50,000 worth of accounts receivable, and $100,000 worth of inventory.

On the liability side of its balance sheet, it has accounts payable worth $100,000 and accrued expenses of $50,000. Here is how to calculate the working capital for this company.

Working Capital = (Cash + Accounts Receivable + Inventory) – (Accounts Payable + Accrued Expenses)

Working Capital = ($100,000 + $50,000 + $100,000) – ($100,000 + $50,000)

Working Capital = ($250,000) – ($150,000)

Working Capital = $100,000

If the company wants to calculate its net working capital ratio, here is how it will do it.

Net Working Capital Ratio = Current Assets / Current Liabilities

Cash, accounts receivable and inventory fall under current assets while accounts payable and accrued expenses fall under current liabilities.

Net Working Capital Ratio = (Cash + Accounts Receivable + Inventory) / (Accounts Payable + Accrued Expenses)

Net Working Capital Ratio = ($100,000 + $50,000 + $100,000) / ($100,000 + $50,000)

Net Working Capital Ratio = ($250,000) / ($150,000)

Net Working Capital Ratio = 1.66

The working capital ratio for the eCommerce clothing company is 1.66.

What If My Business Has Negative Working Capital

There are the types of working capital: positive working capital, zero working capital, and negative working capital. Positive working capital is when the company's current assets exceed its current liabilities. In this case, the working capital ratio is more than 1.

Zero working capital means that the current assets are equal in value to the current liabilities. Here, the working capital ratio is equal to 1.

Negative working capital is when the current liabilities are more than the current assets. The negative working capital carries a negative sign. For negative working capital, the ratio will be less than 1.

When Can My Business Have a Negative Working Capital?

Negative working capital can happen when a company's assets reduce significantly below its current liabilities. It can be due to the payment of a long-term loan or an increase in current liabilities. An increase in current liabilities indicates an increase in accounts payable.

Large purchases from vendors can also lead to negative working capital. When the working capital stays negative for a long while, it can be detrimental to the company’s financial health.

A company with a negative working capital will struggle to carry out its day-to-day operations effectively. Working capital is not static and changes over time. It is why you need to continuously calculate the working capital ratio to be aware of the increase/decrease.

How Can My Business Survive Periods of Negative Working Capital?

Your business can survive periods of negative working capital if it does the following tips. The best way to survive periods of negative working capital is to work on getting out on it. A business can only survive in negative working capital for a period.

1. Reduce Possible Expenses

Once your business has a negative working capital, it is necessary for you to cut all unnecessary spending on equipment, facilities, maintenance, and more to fast track its recovery.

2. Review Tax Payments

You need to check your tax payments record and bills. Are you overpaying? Are there tax breaks your business qualifies for but not taking advantage of?

3. Check Trade Receivables

Contact your customers that have bought a large number of goods on credit. Send reminders to get them to pay quickly.

You can use factoring companies to provide you loans on your unpaid invoices from clients. There are factoring companies that will help collect the money your customers owe on your behalf, subtract their loans and interest, and hand over the balance to you.

4. Negotiate Better Pricing with Suppliers

Ensure you negotiate the price of goods you are supplied with. Try to get them at the lowest price you can get. It saves you some cash which you can use for other purposes.

With these four steps, you can recover from spells of negative working capital within a short time. Remember, negative working capital can render a company insolvent.

Why Managing Working Capital is Important for Business

Every business must keep track of its working capital. It says a lot about the financial health of a business. Here are some of the best advantages of proper working capital management.

1. Smooth Business Operations

A company that keeps track of the working capital will have a smooth run. Companies with large working capital can finance big projects for expansion.

When you manage your working capital, you can track the increase or decrease in the working capital ratio. It will tell you if you are moving to or away from bankruptcy.

For instance, a business internet service provider has been operating for some years with just two branches in the United States. After looking through the balance sheet records, they observed a 0.1 increase in the working capital ratio per year.

When they checked the value of the assets at hand, they saw enough funds to open a new branch. The executives saw the opportunity to expand the business.

2. Increase in Business Evaluations

Companies that manage and record a high working capital generate cash flows. These cash flows increase the evaluation of your business.

When Uber started, it didn't take them a long time to dominate the transportation market. Apart from the large capital the company raised to run its business, the company generated handsome working capital over the years.

Within a few years, they spread across over 200 cities in the world. Today, almost everyone uses it. Uber today is far better than what they were 10 years ago, thanks to its ability to generate continuous positive working capital.

3. Long-term Solvency

The ability to pay short-term loans and other expenses is a massive advantage of managing your working capital.

When you manage your working capital, you find it easy to attend to liabilities appropriately. Liabilities like short-term loans can be paid when due. Attending to these obligations at the right time ensures smooth business operations.

Proper working capital management gives you long-term solvency, which means long years of operation. Companies that find it hard to settle their liabilities on time end up folding up due to bankruptcy.

4. Massive Liquidity

A company managing its working capital well will have high liquidity. It will have enough cash in hand or assets easily converted to currency. Proper management of working capital leads to more liquidity. The implication is that you don't have to depend on external finances from investors and financiers to run a smooth business operation.

5. Ability to Remain Strong during Financial Recession

A company that manages its working capital can stay financially healthy even when sales are done for one reason or the other. Working capital can settle obligations when income is not coming in as expected.

Periods of dry spells are unavoidable in a business. There are days when you experience more sales and days when you make little or nothing. But during these periods of low or no sales, you still have to pay the workers, the utility bills, and short-term loans.

The working capital is what saves the company during times like this. Proper management of working capital is making sure you keep for the rainy days when it is plentiful. Even when the whole industry is facing a financial hit, positive working capital can help absolve most of those blows.

Was This Article Helpful?