Regularly assessing the health of your company is essential. A formula to help you make that assessment is one that every entrepreneur should know how to calculate: working capital. Unpacking the equation is simple, and once you know how, you can make changes to processes and resources that will benefit your company in the long run.
We’re going to walk you through how to calculate net working capital, as well as provide you with some tips to improve it.
What Is Working Capital?
To put it simply, working capital is the amount of money a company has available to pay for day-to-day functions. This equation forms an essential part of financial modeling, and it refers to a company’s ability to pay off its short-term debts.
Components of Working Capital
So, what is included in working capital?
The working capital formula, which we’ll take a look at how to calculate shortly, is divided into assets and liabilities.
Typical assets that can be included in the formula include cash, accounts receivable, inventory, prepaid expenses and marketable securities. These are things that can be converted into cash within a year or less, both tangible and intangible.
Liabilities, on the other hand, are short-term financial obligations that the company must pay within a year or less. Examples of liabilities include accounts payable, taxes, lines of credit, sales taxes owed, short-term loans, the current portion of long term debt and customer deposits.
As a business owner, you should strive to have a positive net working capital balance with more current assets than current liabilities.
Why Is Working Capital Important?
Now on to the important part: why should you care? Working capital is a formula entrepreneurs should pay close attention to because it measures a company’s liquidity and shows how well a business can fund their day-to-day operations.
It also shows whether a company can meet short-term obligations and gives an idea of its ability to invest in activities that will produce income. Working capital indicates business efficiency and financial solvency.
Let’s take a closer look.
How to Calculate Working Capital
It’s essential for business owners to know how to calculate working capital correctly. What we’re calculating is the dollar amount remaining after current liabilities have been subtracted from current assets.
The net working capital formula looks like this:
Net Working Capital = (Current Assets) – (Current Liabilities)
There is a second formula that can be used to find net working capital. It is a slight variation that uses fewer current assets:
Net Working Capital = (Cash and Cash Equivalents) + (Marketable Investments) + (Trade Accounts Receivable) + (Inventory) – (Trade Accounts Payable)
As you can see, the second formula looks specifically at accounts receivable and inventory to provide a fuller picture of a company’s fitness.
You may hear both the terms of net working capital and working capital in financial jargon. You can use both of them interchangeably.
Examples of Working Capital
To put this all in perspective, let’s take a look at a practical example for a fictitious retail store we’ll call XYZ Enterprise. XYZ Enterprise’s assets and liabilities are as follows:
|Current Assets||Current Liabilities|
|Cash: $20,000||Accounts Payable: $20,000|
|Inventory: $10,000||Debt: $10,000|
|Accounts Receivable: $10,000|
|Total: $40,000||Total: $30,000|
As you can see, this company’s current assets are $40,000, and their current liabilities are $30,000. We subtract current liabilities from current assets to get a net working capital of $10,000, meaning this company has positive net working capital.
Positive vs. Negative Working Capital
When you calculate net working capital, the outcome you want is a positive number. What does it mean to have a positive working capital?
Quite simply, it’s an indication that your business is in good financial health. Healthy firms can meet current financial responsibilities, and positive working capital indicates an ability to invest in other operational needs.
Negative working capital, on the other hand, may mean many things:
- You need to find more efficient ways to use short-term assets
- Your company lacks assets to meet current financial obligations
- You’re struggling to maintain or expand sales
What are some of the consequences of negative working capital?
Negative working capital can cause increased financial pressure, increased borrowing and late payments that result in a lower credit score. This low credit score can mean higher interest rates from banks, which in the long run, costs businesses more money.
Despite being an indicator of negative company health, a negative number doesn’t mean a company will go bankrupt.
On the contrary, certain companies do well despite negative working capital. Those with high inventory turnovers, like grocery stores and discount retailers, are good examples of enterprises that can be highly profitable despite negative working capital.
Similarly, a positive number doesn’t guarantee a company’s success. Having a positive number isn’t great if a company can’t collect on accounts receivable in a reasonable amount of time, which causes a gap in cash flow.
Net Working Capital Ratio
Net working capital ratio is another way to compare assets and liabilities. This ratio gives an idea as to whether or not a company has short-term assets to cover short-term debt.
Finding your company’s net working capital ratio is simple. You divide the numbers instead of subtracting them to get a ratio. The formula is as follows:
(Current Assets) / (Current Liabilities)
The working capital ratio should be between 1.2 and 2.0. In the example above, XYZ Enterprises would come out with a ratio of 1.3, indicating that their business is healthy.
If the ratio is higher than 2.0, this signifies that you’re not effectively using current assets to generate revenue. On the other hand, if the ratio is less than 1.0, you may have potential liquidity issues, which can be a red flag.
Keep in mind that this ratio might be misleading if a business has lots of inventory. As far as current assets go, it’s not always possible to liquidate inventory in the short term.
How to Calculate Change in Net Working Capital
Once you know how to calculate net working capital, it can be useful to calculate the change in net working capital over time. Doing so will allow you to compare how your business assets are performing from one period to the next—generally in yearlong increments, but you can calculate change quarterly as well.
How do you calculate change in net working capital? The formula is simple:
(Current Net Working Capital) – (Previous Net Working Capital)
It’s important to remember that this calculation doesn’t paint the whole picture. Sometimes businesses strategically decide to increase short-term liabilities for a certain period, which can cause adverse fluctuations.
That said, we do recommend tracking change in net working capital so you can keep an eye on your operating cash flow (OFC).
How to Improve Net Working Capital: 4 Tips
Once you know how to find change in net working capital, it’s possible that you may want to try and improve it. The good news is that by making some improvements, net working capital is highly changeable.
Here are four tips that can help you achieve positive net working capital:
1. Move Inventory Faster
Although inventory is considered an asset in the working capital formula, it’s less liquid. In other words, cash is tied up in inventory, which means if you’re storing inventory for long periods, you may find yourself without cash. The solution? Move your inventory faster.
We recommend doing this by not over-ordering, by focusing on quick-selling inventory and by re-evaluating stock items that sell slowly. You can also return unused inventory to suppliers in exchange for a restocking fee.
2. Liquidate Long-Term Assets
Long-term assets have the same problem as inventory—they tie up your cash in things like equipment and buildings. If you’re not using long-term assets, you may want to sell them to increase your cash flow.
If you have extra office space, sell or rent part of it. The same goes for machinery you no longer use.
Be careful not to get rid of all your assets, however, which may be needed for collateral if you’re applying for loans.
3. Refinance Debt
Refinancing is a good option for those with a history of on-time payments.
Refinancing will allow you to increase working capital by turning short-term loans (loans that will be paid in a year or less) to long-term debt. Refinancing lengthens payment schedules, gives you a lower monthly payment and ultimately means you have more cash for working capital.
4. Speed Up Accounts Receivable
Another place your money gets tied up is in invoices. Reduce the accounts receivable period to improve your working capital, and try to encourage early payment by implementing discounts for quick payment.
As an entrepreneur, it’s essential to know how to calculate working capital. We hope you see that the formula is not at all complicated to understand and that you take advantage of this useful tool to understand your company’s health.