What Is Working Capital? How to Calculate and Why It’s Important

Working capital is the difference between current assets and current liabilities. Businesses don’t go bankrupt because they are not profitable. They go bankrupt because they run out of cash and can’t meet their payment obligations as they come due.

Profitable, growing companies can also run out of cash, because they need increasing amounts of working capital to support additional investment in inventories and accounts receivable as they grow.

Working Capital Ratio

What Is Working Capital

  • It is a financial metric calculated as the difference between current assets and current liabilities.
  • Positive working capital means the company can pay its bills and invest to spur business growth.
  • NWC management focuses on ensuring the company can meet day-to-day operating expenses while using its financial resources in the most productive and efficient way.

Working capital is the difference between current assets and current liabilities. “Current” again refers to the fact that these items fluctuate in the short term, increasing or decreasing along with operating activities.

Generally, these are assets that can be converted into cash within the next 12 months or the operating cycle, such as inventory and accounts receivable. Current assets include cash, short-term investments, accounts receivable, and inventories.

It is the money used to pay short-term debts? NWC is calculated by subtracting current assets from liabilities. Assets must be readily available to be turned into cash, (if not cash itself), to cover current liabilities.

Working capital can show the overall financial health of a small business. Positive working capital shows a business is able to pay off short-term liabilities readily. Negative capital may indicate financial problems such as slow sales, or collection problems

How do I calculate my working capital ratio?

The working capital ratio is calculated simply by dividing total current assets by total current liabilities. For that reason, it can also be called the current ratio. It is a measure of liquidity, meaning the business’s ability to meet its payment obligations as they fall due.

The working capital ratio is calculated as follows:

Current assets / Current liabilities = Working capital ratio

In general, the higher the ratio, the greater your flexibility to expand operations. If the ratio is decreasing, you need to understand why. The ideal ratio depends on your industry and particular circumstances. If it is less than 1:1, this usually means you are finding it hard to pay bills.

Even when the ratio is higher than 1:1, you may have difficulty, depending on how quickly you can sell inventories and collect accounts receivable. A ratio of 2:1 usually provides a reasonable level of comfort.

How to Calculate Working Capital

Working capital is calculated as current assets minus current liabilities, as detailed on the balance sheet.

Formula for Working Capital

Working capital = current assets – current liabilities

To calculate the business’s operating cycle, find out how long it takes to sell inventories and collect accounts receivable. A business with a long operating cycle should have a higher working capital ratio than one with a shorter cycle.

Net Working Capital

Analysis of the Working Capital

The analysis of current liabilities is important to investors and creditors. Banks, for example, want to know before extending credit whether a company is collecting—or getting paid—for its accounts receivables in a timely manner.

On the other hand, on-time payment of the company’s payables is important as well. Both the current and quick ratios help with the analysis of a company’s financial solvency and management of its current liabilities.

Quick Ratio Vs Current Ratio (Working Capital Ratio)

Analysts and creditors often use the current ratio. The current ratio measures a company’s ability to pay its short-term financial debts or obligations. The ratio, which is calculated by dividing current assets by current liabilities, shows how well a company manages its balance sheet to pay off its short-term debts and payables.

It shows investors and analysts whether a company has enough current assets on its balance sheet to satisfy or pay off its current debt and other payables.

The quick ratio is the same formula as the current ratio, except it subtracts the value of total inventories beforehand. The quick ratio is a more conservative measure for liquidity since it only includes the current assets that can quickly be converted to cash to pay off current liabilities.

A number higher than one is ideal for both the current and quick ratios since it demonstrates there are more current assets to pay current short-term debts. However, if the number is too high, it could mean the company is not leveraging its assets as well as it otherwise could be.

Calculate Working Capital

Reasons why your business might require additional working capital

  • Seasonal differences in cash flow are typical of many businesses, which may need extra capital to gear up for a busy season or to keep the business operating when there’s less money coming in.
  • Almost all businesses will have times when additional working capital is needed to fund obligations to suppliers, employees and the government while waiting for payments from customers.
  • Extra working capital can help improve your business in other ways, for example: enabling you to take advantage of supplier discounts by purchasing in bulk.
  • Working capital can also be used to pay temporary employees or to cover other project-related expenses.

Why is Net Working Capital (NWC) important?

NWC is important because it is necessary for businesses to remain solvent. In theory, a business could become bankrupt even if it is profitable. After all, a business cannot rely on paper profits to pay its bills—those bills need to be paid in cash readily in hand.

Say a company has accumulated $1 million in cash due to its previous years’ retained earnings. If the company were to invest all $1 million at once, it could find itself with insufficient current assets to pay for its current liabilities.

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