What is Working Capital?
Whether you’re looking to grow your business or finance bigger projects, you will need working capital. At its core, working capital supports your daily running costs, funds operations, and may help you stay afloat during tough times. It ensures your company is operating efficiently by providing a barometer of its assets and liabilities.
By monitoring this metric in real time, a company puts itself in a better position to ensure there is adequate cash flow to meet short-term operating costs and debt obligations. Insufficient working capital results in a shortage of resources. Learn what working capital is, why it is important, and how to calculate it.
What Is Working Capital?
Simply put, working capital is the money you have in hand, whether in the form of a bank loan, retained profit, or any other form of liquid capital. It funds your day-to-day operations, helps you pay salaries and rent, and offsets other operating expenses.
More technically, working capital is the money that remains when a business settles all its current liabilities with its current assets. Current liabilities are the debts that are due in one operating cycle or fiscal year. Current assets are any assets that a business intends to use over the same period.
Working capital is more than a measure of a company’s liquidity. It also provides valuable insight into its short-term financial health and operating efficiency. Theoretically, a business with positive working capital has the extra funds needed to reinvest in the business to finance growth. If the working capital is negative — liabilities being more than assets — a business may have trouble paying back debt on time and in the right amounts.
You might have also come across the term gross working capital. This is the sum of assets a company can convert into cash within a 12-month period. Gross working capital doesn’t factor in your business liabilities, so it may not provide an accurate picture of your finances. For that reason, working capital is also referred to as net working-capital.
Why Is Working Capital Important?
Your business needs some amount of working capital to sustain its operations, including paying bills, wages, keeping its cash flow strong, and remaining solvent. Here are other reasons why working capital is important.
May Help Smooth Out Revenue Fluctuations
If you run a seasonal business, chances are that you’ll experience seasonality in sales, selling less in some months and more during others. During peak season, you may need to bring in additional staff to help with operations. In the off-season, you may have less revenue to cover the higher expenses. With sufficient working capital you can meet your financial obligations during the months when you generate less revenue, and adequately prepare for the busy months.
Improves a Company’s Creditworthiness
With sufficient working capital, your business is in a better position to meet its debt obligations, including paying creditors and vendors in a timely manner. Prompt payments improve your creditworthiness, which may help you to borrow additional funds as needed.
Funds Growth or Bigger Projects
If your business operates on a project-by-project basis, you’ll need to take into account ebbs and flows in your cash flow. For example, if you take on a large project that only pays upon completion, you’ll need funds to sustain your operations in the interim.
Signifies Good Management
Healthy working capital doesn’t just show a company’s liquidity, it also reflects its operational efficiency and how well it’s turning over inventory and handling accounts payable and receivables. These metrics show that a company is headed in the right direction. For investors, a strong capital position represents a good company to invest in.
How to Calculate Working Capital
Businesses maintain accounting records and compile financial data in financial reports. To calculate working capital, you’ll need a company’s statement of financial position, also known as the balance sheet. The formula for calculating working capital is as follows:
Working Capital = Current Assets – Current Liabilities
Current assets and current liabilities are both balance sheet entries. Current assets are any assets your business can liquidate or convert into cash within a financial year. This doesn’t include fixed assets that are recorded as long-term assets on the balance sheet. Current assets include:
- Cash, which includes money in bank accounts and undeposited customer checks.
- Marketable securities, like money-market funds and U.S. Treasury bills.
- Short-term investments that you’ll sell within one year.
- Notes receivable, such as short-term loans to suppliers maturing within one year.
- Accounts receivable.
- Other receivables, like income tax refunds, insurance claims, and cash advances to employees.
- Prepaid expenses, like insurance premiums.
- Inventory, including any raw materials, finished goods, or work in process.
- Advance payments made for future purchases.
Current liabilities are the short-term obligations a business must settle within one year. These include:
- Notes payable due within one year.
- Accounts payable.
- Unpaid taxes.
- Unpaid wages.
- Interest payable on credit facilities.
- Any loan principal that is payable within a year.
- Any other accrued expenses payable.
- Deferred revenue, like advance payments for goods and services not yet delivered.
Let’s say your balance sheet entries for current assets and current liabilities are $10,000 and $6,000 respectively. Your working capital is $4,000 ($10,000 – $6,000).
You may have also come across the working-capital ratio, a metric that also reflects a company’s financial health. You can obtain the working capital ratio by dividing current assets by current liabilities, as shown below.
Working-capital ratio = Current Assets/Current Liabilities
This ratio helps you to establish whether there’s sufficient operating capital to cover your short-term debt. Ideally, the working-capital ratio should be at least 1. A ratio below 1 indicates a business has negative working capital. Anything exceeding 2 indicates that a business has too much cash tied up and isn’t investing the excess working capital.
How to Increase Working Capital
Working capital measures your business’s operating liquidity. A company may want to increase its working capital if it is anticipating a temporary plunge in sales or wants to cover project-related expenses. In this case, you can tactically increase your current assets or reduce current liabilities in the following ways:
- Refinancing short-term debt with longer-term credit. This reduces your current liabilities.
- Liquidating assets for cash, therefore increasing your current assets.
- Evaluating and reducing expenses, which reduces current liabilities.
- Optimizing inventory management to ensure you’re not tying up too much cash in inventory or raw materials.
- Taking on long-term debt, thus increasing your business’s available cash.
The Bottom Line
Working capital is crucial for your day-to-day operations, funding business growth, and surviving uncertain murky economic times. That’s why you must get to grips with it, learn how to calculate it, interpret it, and increase it to your advantage.
Positive working capital is synonymous with liquidity, operational efficiency, and great financial health. Negative working capital means you’re falling behind on your debt obligations. Tracking working capital is crucial in monitoring your current levels of cash in hand while taking action to mitigate future cash deficiencies.