What is Working Capital and How Does it Affect Your Business?
What is working capital?
Working capital is the difference between a company’s current assets and liabilities. It’s the money that a business can use to cover its short-term expenses, such as inventory, payroll, and accounts payable. The actual funds that are available to pay for the day-to-day costs of running a business. Keeping control of your net working capital is crucial to maintaining the financial health of your business.
There are two numbers that are useful to know when talking about working capital: your working capital ratio, and your net working capital. The ratio is the relative amount of profit compared to costs. For instance, if a business makes the same amount of money as it costs to run, its ratio would be 1.0. If it makes slightly more than it costs, the ratio might be 1.2.
The net working capital is the flat dollar amount made in excess of operating costs.
Calculating your working capital ratio
To calculate your working capital ratio, you’ll need to gather a few figures first. This will help you understand how much working capital your business currently has in comparison to its liabilities. To get started, you’ll need to know your current assets and current liabilities. Once you have those figures, divide your current assets by your current liabilities to get your working capital ratio.
If the resulting number is one or more, then you have enough money to cover short-term expenses.
While theoretically, a business can function and meet expected expenses with a working capital ratio of 1.0, getting that number higher with additional working capital is preferable so that there is some buffer room for unexpected costs and extra money to reinvest into the business.
Working capital ratio formula
To calculate working capital use:
Working Capital Ratio = Current Assets / Current Liabilities
What is a good working capital ratio?
The higher the ratio, the more excess cash your business generates, which is usually good. A ratio closer to 1.0 is still a positive working capital, but it means cash is a little tighter, and it’s worth keeping an eye on your current liabilities and accounts payable.
If your ratio is below 1.0, it is called negative working capital. It indicates cash flow problems now or in the immediate future, impacting the company’s ability to pay short-term liabilities and fund operations.
Calculating your working capital
The method for calculating your actual monetary amount of capital, usually called net working capital, is very similar to calculating the ratio. The first step is to determine your total current assets. This includes any cash on hand, accounts receivable and inventory. The second step is to determine your current liabilities. This includes accounts payable, short-term debt, and other accrued expenses due within the following year. Once you have these two figures, subtract your liabilities from your assets, and you will have your working capital.
This figure can be helpful for a few purposes. For starters, it can help small business owners measure their company’s liquidity – or how quickly you can convert your assets into cash. It can also help identify any potential areas of improvement when it comes to managing your finances. And finally, it can give you a snapshot of your company’s overall financial health and capacity to fund business growth.
Working capital formula
To calculate working capital use:
Working Capital = Current Assets – Current Liabilities
Working Capital FAQs
What is working capital and an example?
Working capital is the number of extra funds a business has after subtracting all current liabilities from accounts payable. For example, if a company has $350,000 in current assets and $200,000 in liabilities, then its working capital would be $150,000, the difference between revenue and costs.
How is working capital calculated?
Working capital is calculated by subtracting a business’s liabilities from its assets. You can also calculate the working capital ratio by dividing the assets’ cost by total liabilities.
What are some uses of working capital?
Working capital measures a company’s ability to pay short-term obligations. There are many ways to use working capital, including:
-Measuring the company’s ability to pay short-term obligations.
-Analysing financial health and capacity for growth.
-Identifying potential areas of improvement in finances.
-Determining cash flow problems and solutions.
What are the four main components of working capital?
The four most relevant components when calculating a business’s working capital are:
- Cash and Cash Equivalents.
- Accounts Receivable.
- Inventory and Stock.
- Accounts Payable.
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