Working capital is the difference between a company’s current assets and current liabilities; so when you subtract the latter from the former, you have your working capital.
However, the trick here is to know your current assets and liabilities before applying this formula. It’s common for new business owners to confuse what counts as an asset or a liability, which is where this article will help.
Today, we’ll teach you to calculate your working capital without consulting a finance book to see where you currently stand. And don’t worry, this isn’t some complex maths; instead, knowing the two pillars, i.e., your assets and liabilities, is enough to find the final number. Keep reading, and it’ll be clear by the end.
What is Working Capital?
Working capital is the money a business has for its short-term operating needs and to keep its cash flow cycle moving. Since every business cycle starts with cash going out before it comes back in, working capital funds that gap. It’s loosely defined as the in-between money before your spent funds return as payments and profit.
In this context, by current assets, we mean anything that can be converted into cash pretty quickly. For example, the money already in your bank account, accounts receivable that show as $$ as soon as customers pay their bills, investments that can be sold off, and unsold inventory.
At the same time, liabilities are the expenses of running a business you must clear within a short period. For example, your rent, staff salaries, loan installments, interest payments, dividends, and taxes payable.
With that settled, here is how we find working capital for any business:
Current assets – current liabilities = Working capital
Let’s say a small retail business’s current assets are:
- Cash: $20,000
- Accounts receivable: $15,000
- Inventory: $25,000
Total = $60,000
At the same time, this business’s liabilities are:
- Accounts payable: $18,000
- Short-term loan payments due this year: $12,000
Total = $30,000
Here’s how we find its working capital:
$60,000 − $30,000 = $30,000
This business has $30,000 available to cover day-to-day expenses after settling its short-term obligations, and is in the positive range.
Now think about a business whose assets that can be converted to cash within a year are $500,000, but liabilities it must cover within the same period are $700,000, including everything. In this situation, the business’s working capital will be -$200,000, which is not a very healthy position.
Here is how you perceive these situations:
Current assets > current liabilities = Positive working capital
Current assets < current liabilities = Negative working capital
It goes without saying that every business needs a sustainable cash flow to meet its obligations and fund all crucial aspects without cutting corners. Hence, businesses aim to maintain a positive working capital; even if they don’t have it all available as cash, their inventory, short-term investments, and unpaid invoices can back them up.
Preferred Working Capital for Any Business
Working capital allows you to very quickly gauge your company’s financial health. Being in the positive zone means you’re able to cover liabilities without needing working capital financing or selling an asset. And vice versa. But it’s not always this simple, as some businesses can continue their sales cycles without high working capital.
That said, working capital is usually summarized as a ratio, instead of a dollar figure, so a business can compare itself with others of the same size and market. The preferred ratio is 1.5 – 2.0; let us break that down for you:
Ratio of 1.0
A ratio of 1.0 means your current assets match liabilities, and there is nothing left after covering the non-negotiable expenses. For instance, a business with $80,000 in assets and $80,000 in liabilities sits at this breakeven point. While it can technically cover its obligations, there’s no cushion, and any delay in collecting receivables or unexpected expense could mean trouble.
Ratio of 1.5
1.5 ratio means a business has $1.50 in current assets for every dollar it owes as expenses or payables. For example, $90,000 in current assets and $60,000 in current liabilities gives a ratio of 1.5, which is generally a healthy position. This business will have enough liquidity to cover debts and still has working funds for operations, without excess cash sitting idle.
Ratio of 2.0
This simply means current assets are double the current liabilities. So a business with $120,000 in current assets and $60,000 in liabilities falls here. However, while this number will look positive, a ratio this high can also mean the business is holding too much cash or unsold inventory instead of reinvesting it. Therefore, staying at that sweet spot of 1.5 is optimal.
Conclusion
Numbers can seem overly complicated, but oftentimes they are not. If your balance sheet clearly mentions assets and liabilities in separate columns, finding working capital will take a few seconds. But if the results aren’t per your expectations, business financing might be inevitable to keep you afloat, and that’s when ROK Financial will help. We make sure no business has to cut corners or feel broke just because of some discrepancies in the balance sheet. Let’s figure this out together.
FAQs
Does working capital change throughout the year?
Yes, working capital varies with seasonal demand, sales cycles, and payment terms. For example, a retail business’s working capital might dip before a busy season because it had to purchase inventory. But it’ll soon rise after sales come in.
What’s a common mistake businesses make with working capital?
A common mistake is tying up too much cash in inventory or receivables that take a long time to collect. This creates the appearance of financial health on the balance sheet while usable cash stays limited.
Is negative working capital always bad?
While positive working capital is preferred, negative is not always bad. Some business models, like subscription services or those that collect payment before delivering goods, can operate with negative working capital.