Working capital is a metric used to quantify your company’s liquidity. In other words, it is the amount of money you would have on hand to run your business if you were to liquidate your assets to pay off your current debts. This calculation is an effective way to analyze your organization’s short-term financial health and operational efficiency. The most commonly used working capital formula to calculate working capital is:
Assets – Liabilities = Working Capital
A healthy total tells you that your business has the means to meet its short-term obligations comfortably. A small or even negative number could spell trouble ahead for your firm. Knowing the amount of working capital you have on hand can empower you to make prudent choices regarding financial stabilization or even corporate expansion. Although the working capital formula seems straightforward, it can be complicated if its components are defined incorrectly. What is considered an asset, and what liabilities should you include when calculating the working capital formula? These components are typically found on a company’s balance sheet. Let’s take a closer look.
Definition of Working Capital
Working capital is a financial metric that measures a company’s liquidity and its ability to meet short-term obligations. Essentially, it is the difference between a company’s current assets and current liabilities. This metric is crucial because it indicates whether a business has enough liquid assets to cover its short-term debts and expenses. In simpler terms, working capital is the lifeblood of day-to-day operations, ensuring that a company can maintain smooth operations without financial hiccups. By keeping an eye on working capital, businesses can better manage their cash flow and make informed decisions about investments and growth opportunities.
Which Assets to Include
The working capital current assets you need to calculate your working capital formula include tangible and intangible resources currently liquid or converted into cash within a year. This would include:
- Cash on hand—Checking, saving, and money market account balances
- Short-term securities—Certificates of deposit or treasury bills, which have relatively short maturity periods
- Inventory—Product that you expect to sell in the near future
- Marketable securities—Stocks, bonds, and exchange-traded funds (ETFs) that can be sold quickly and at fair market value
- Accounts receivable—Money owed to you, including checks received that you have not yet cashed
- Interest receivable—Accrued interest that you have not yet collected on loans, notes, or other forms of credit extended by your business
When the company’s current assets exceed its current liabilities, it indicates strong financial liquidity and short-term soundness.
On the other hand, illiquid assets are those that you cannot sell in the short term—either because there is no immediate market for them or because they would lose a significant percentage of their value in the sale. Since they are held for the long term, do not include the following asset classes when calculating your working capital:
- Real estate—Equity on your property holdings
- Hedge funds—Invested in liquid assets like stocks and bonds, but investors can’t access the funds quickly
- Mutual funds—Traditional funds, as opposed to the more liquid ETFs mentioned above
- 401(k) or other retirement accounts—Accessing before retirement age would incur significant tax penalties
- Artwork or other collectibles—Usually not a big enough pool of buyers to sell quickly and at fair market value
Which Liabilities to Include
Likewise, the liabilities included in your working capital calculation should only include expenses that your company is obligated to pay within the next year. These include:
- Short-term borrowed funds—Loans, lines of credit, or cash advances taken out by your business with a payback term of less than a year
- Principal payments—The monthly payments to pay down the principal owed on long-term loans
- Interest payable—Accumulated interest on your company’s borrowed funds
- Accounts payable—Invoices that you still need to pay
- Dividends payable—Dividends owed to investors
- Operational expenses—Money paid toward rent, materials, supplies, and utilities
- Accrued income taxes—Tax payments your company has scheduled to make to the IRS
Do not include the portion of long-term debts you are not paying back in the next 12 months. Because you are only considering your assets and liabilities in terms of how they will affect your daily finances over the next year, your working capital computations could change month to month or day to day. For example, you plan to sell a piece of real estate in 18 months. The property’s equity will not affect your working capital today; however, it should be added to your equation in six months because, at that point, you’ll be a year from liquidating the asset.
Components of Working Capital
Working capital is composed of two main components: current assets and current liabilities. Current assets include cash, accounts receivable, inventory, and other assets that can be converted to cash within a year. These assets are crucial for day-to-day operations, providing the necessary liquidity to handle immediate expenses. On the other hand, current liabilities encompass accounts payable, short-term loans, and other debts that must be settled within a year. The working capital formula is calculated by subtracting total current liabilities from total current assets. This calculation provides a snapshot of a company’s short-term financial health, indicating whether it has enough resources to meet its immediate obligations.
Alternative Net Working Capital Formulas
Although assets minus liabilities is the standard formula, there are alternatives that your company could use. These are tailored to more specific scenarios. Use these alternative working capital formulas in tandem with the standard calculation to determine how particular variables like inventory and cash on hand impact your working capital. The net working capital formula, which is current assets minus current liabilities, is foundational for evaluating a company’s ability to manage its short-term financial obligations.
If you want to examine how balanced your daily operations are, use the following formula:
Inventory + Accounts Receivable – Accounts Payable = Working Capital
Or, to take cash out of the equation:
Assets – Liabilities – Cash = Working Capital
The working capital ratio formula, which compares current assets to current liabilities, provides insight into a company’s ability to manage its debts and operational demands effectively. These additional calculations can pinpoint what operational area might be dragging down your working capital. You can then make adjustments as necessary to shore up those segments of your business, strengthening your short-term financial footing.
Interpreting Working Capital Results
Interpreting working capital results is essential for understanding a company’s financial health. A positive working capital indicates that a company has sufficient liquid assets to meet its short-term obligations, suggesting a strong liquidity position. Conversely, a negative working capital suggests potential difficulties in paying bills and meeting short-term debts. However, the context is key. For instance, a company with negative working capital might still be financially healthy if it can quickly turn over its inventory or has strong cash flow from operations. Therefore, while working capital is a critical metric, it should be considered alongside other financial indicators to get a comprehensive view of a company’s financial stability.
Positive Working Capital
A positive working capital is generally a good sign, indicating that a company has enough liquid assets to meet its short-term obligations. This suggests a strong liquidity position, which can help a business weather financial storms and seize new opportunities. However, it’s important to note that an excessively high positive working capital might not always be beneficial. It could indicate that the company has too much idle capital or an overstock of inventory, which could be better utilized elsewhere. Therefore, while positive working capital is desirable, it’s crucial to strike a balance to ensure optimal use of resources.
Negative Working Capital
Negative working capital is often viewed as a red flag, indicating potential difficulties in meeting short-term obligations. However, it doesn’t always spell disaster. In some cases, a company might operate efficiently with negative working capital if it has a high turnover of inventory or strong cash flow. For example, a business with a high accounts payable balance might still be financially healthy if it can quickly convert its inventory into cash. Therefore, while negative working capital warrants attention, it’s essential to consider the broader financial context and the company’s ability to generate returns on its investments.
Reasons for Negative Working Capital
At one time or another, most businesses need more working capital than they have available. Assessing the company’s ability to utilize its current assets effectively is crucial in these situations. Your company could experience a temporary shortage due to:
- Outstanding customer invoices: Customers may be slow to pay, but your obligations like payroll and bills can’t wait.
- Seasonal fluctuations: Industries like retail or landscaping face high demand during certain months but experience slower periods. Managing the company’s working capital during these times is essential to maintain liquidity.
- Bulk buying opportunities: You might make large upfront purchases for supplies or inventory to save money in the long run by taking advantage of discounts.
