Working capital (also known as net working capital) is the amount of money your business has available to cover daily operating expenses such as payroll, lease and utility payments.
From an accounting standpoint, working capital is the difference between your business’s current assets and its current liabilities. Here’s what those
accounting terms mean:
Current assets. A current asset, also known as a short-term asset, is a liquid asset. That means it can be liquidated into cash within the next 12 months if necessary. Current assets include cash and cash equivalents (for example, treasury bills and money market funds) and other short-term assets, such as accounts receivable,
inventory and prepaid expenses.
Current liabilities. These are any short-term liabilities or financial obligations payable within the next 12 months. For example, your accounts payable — which is what you owe your suppliers and vendors — is a current liability. A business loan is typically a long-term liability, but the monthly payments you make on the loan are categorized as a current liability.
To calculate your working capital, you need to know your total
current assets and total current liabilities. You can find these numbers in your most recent
balance sheet. If you don’t have a recent balance sheet prepared, you’ll need to add up all of your current assets and current liabilities separately to get the numbers you need.
The formula for calculating working capital is simple:
current assets – current liabilities = working capital
Plug your own current assets and current liabilities into this formula to determine your net working capital.
Here’s an example. Let’s say you have current assets of $20,000 in accounts receivables, $20,000 in inventory, and $20,000 in cash, for a total of $60,000 in current assets.
You have current liabilities of a $5,000 lease payment, $20,000 in payroll costs, a $10,000 tax installment, and $5,000 in accounts payable, for a total of $40,000 in current liabilities.
Using these numbers, you would have working capital of $20,000 ($60,000 – $40,000 = $20,000).
Ideally, your working capital will be a positive number, which means you have enough money to cover your day-to-day operating expenses. If your current liabilities are greater than your current assets, you’ll have negative working capital — meaning you don’t have the funds to pay short-term debts as they come due.
Temporary factors, such as a significant cash purchase of a long-term asset, can result in negative working capital in the short-term. Negative working capital every once in a while might not be an issue. It can become a concern, however, if you’re seeing negative numbers consistently.
Your Working Capital Ratio
Also known as the current ratio, the working capital ratio is a financial ratio that helps you assess your business’s liquidity. To determine your working capital ratio, take the same figures you plugged into the working capital equation and compare them in a ratio format.
Use the following formula to calculate your working capital ratio:
current assets ÷ current liabilities = working capital ratio
Your result will be a decimal. For instance, from the example above, you would have a working capital ratio of 1.5 (60,000 ÷ 40,000 = 1.5).
A working capital ratio of
between 1.5 and 2.0 indicates your business is in good financial health. It means you have the funds to cover your short-term liabilities as they come due, and you also have enough working capital to provide a financial cushion if your business experiences a bad month.
If You Have a Low Working Capital Ratio
You don’t want to see your working capital ratio fall below 1.0, since this means you have more current liabilities than current assets — which can have disastrous consequences when it comes time to pay your monthly bills.
While a low working capital ratio can be manageable in the short term, over time it signals a business’s inability to meet its liability obligations. So if you find yourself looking at a low working capital ratio consistently, it might indicate a problem with your current business model.
If You Have an Excessively High Working Capital Ratio
A working capital ratio that’s too high isn’t necessarily a good sign. It could mean your business has money laying around that isn’t being put to good use. This might be a sign to assess your current assets to see if you have funds you could invest in something that would give your business a better return.
For example, let’s say you have $120,000 in current assets, $50,000 cash in your business bank account and $25,000 in current liabilities. This means you have a working capital ratio of 4.8.
This ratio is quite high. With $50,000 sitting in your bank account, you may want to consider putting some of this idle cash to use by investing it.
