Working Capital Calculation

BusinessZeal Staff Nov 3, 2018
Managing the working capital of your business is essential for its survival. Learn what is working capital, and how do we go about calculating it.

Working Capital Management

In order to manage your working capital in an effective way, make timely payment to your creditors, and keep cash on hand for catering to the short-term financial needs of the business.
Working capital is a financial metric that measures a company's liquidity and ability to pay off short-term loans. It also determines the company's operational efficiency. A business has to effectively manage its working capital in order to maintain a positive credit standing and reputation in the market.
Before getting to the part about how working capital can be calculated, it is essential to define a couple of terms related to the calculation of working capital.

Working Capital Basics

Current Assets
Current assets are generally those assets which can be liquidated quickly. The general assumption is that when you look to the assets' side of the balance sheet, certain items like cash-in-hand, cash at bank, marketable securities, working inventory, etc., fall under current assets.
Current Liabilities
Current liabilities are those liabilities that will have to be paid sooner or later. The payment date for current liabilities is not fixed, and the debt might mature anytime. So, typically, current liabilities is the sum of the amount owed to the creditors, bills payable, dividend, wages, etc.

Calculating Working Capital

Current Assets
Cash $100,000
Prepaid expenses $1,500
Securities $5,000
Inventory $50,000
Accounts receivable $3,000
Total $159,500
Current Liabilities
Accrued expenses $50,000
Accounts payable $3,000
Tax $10,000
Dividend $10,000
Wages $20,000
Total $93,000
Working Capital = Current Assets - Current Liabilities

Hence,
$159,500 - $93,000 = $66,500 (Working capital)
The current assets have been placed first in the formula as the working capital ought to be positive, i.e., the total of the current assets should be more than that of the current liabilities. It is often twice the total of the current liabilities to mitigate any unforeseen risk factors.

Impact of Positive Working Capital

If the current assets are more than current liabilities, it will have a positive working capital.
A positive working capital indicates that the company has Liquidity of funds, Funds to meet the current obligations of the business, Enough funds for maturing short-term debt, Funds to allocate for operational expenses, Funds to expand the business with limited or zero borrowing.

Impact of Negative Working Capital

If the current liabilities are more than current assets, it is known as a working capital deficit.
A negative working capital indicates that the company has a lower volume of sales, less number of bills receivables, lack of operational efficiency, Increased borrowing of funds, Late payment of dues, Lower credit rating.

Merits of Negative Working Capital

Under certain circumstances, negative working capital is also helpful for a company. Such companies are often better at raising cash as compared to those with a positive working capital. Also, they are adept at generating free cash flow when they want to increase their revenues.
A negative working capital is highly beneficial for a company, especially if it is planning to reduce its revenue. However, remember that only a few industries can actually benefit from a negative working capital. For example, it is not recommended for the highly risky and expensive automobile industry.

Current Ratio

Current ratio often depicts the capability of the company to pay off short-term loans, and it helps measure the liquidity of the firm.
You can calculate the current ratio by applying the following formula.

Current ratio = Current assets/ Current liabilities

Hence,

$159,500/$93,000 = 1.71 (Current ratio)
Here,
Current ratio > 1 = The company is efficient enough to pay its obligations.

Current ratio < 1 = The company may not be able to pay off its obligations in time.
It is often stated that the acceptable current ratios lie between 1.5 and 3 for healthy businesses. However, ratios may vary between this range for various industries.
So, this was all about calculating working capital. Remember that the working capital amount which hardly involves 4-5 balance sheet items, with usually the lowest amounts in the whole sheet, if ignored, can even lead to bankruptcy or at least, lead to short term debt settlement problems.
How? If your current liabilities exceed the assets, and you do not have liquid funds to pay your creditors, then the business might find itself in a real fix. Secondly, the working capital shows the efficiency in running the business.
A low capital, generally, indicates that your debtors pay you slowly (your collections are low), while your creditors are a lot more demanding. Hence, ensure that you have a favorable working capital for your business.
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