Working capital is the money a business can quickly tap into to meet day-to-day financial obligations such as salaries, rent, and office overheads. Tracking it is key since you need to know that you have enough cash at your fingertips to cover your costs and drive your business forwards. But the costs you need to cover are unlikely to remain static.
In fact, research from American Express reveals that 52% of UK small businesses say that the rising costs of goods, services, and energy present the biggest challenge to the running of their business and 28% are looking at additional ways to improve their cash flow as a result.
Here’s a look at how to calculate your key working capital requirements.
How to calculate working capital
The working capital formula subtracts your current liabilities (what you owe) from your current assets (what you have) in order to measure available funds for operations and growth. A positive number means you have enough cash to cover short-term expenses and debts, whereas a negative number means you’re struggling to make ends meet.
Working capital formula
The working capital calculation is:
Working Capital = Current Assets - Current Liabilities
For example, if a company’s balance sheet has 300,000 total current assets and 200,000 total current liabilities, the company’s working capital is 100,000 (assets - liabilities).
Let’s look at each of these in more detail.
Anything owned by your business that can be converted into cash within 12 months is a current asset. They may include:
- Cash equivalents (investments that can be quickly converted into cash, like government bonds).
- Accounts receivable (e.g. outstanding invoices).
- Stock (including raw materials, work-in-process, finished goods and packaging).
- Short-term investments.
- Prepaid expenses.
Current liabilities include any bills or debt that you haven’t paid yet, including:
- Accounts payable (e.g. supplier payments).
- Bank overdrafts.
- Sales, payroll, and income taxes.
- Short-term loans.
- Outstanding expenses.
Working capital ratio formula
The working capital ratio shows the ratio of assets to liabilities, i.e. how many times a company can pay off its current liabilities with its current assets.
The working capital ratio calculation is:
Working Capital Ratio = Current Assets / Current Liabilities
It’s useful to know what the ratio is because, on paper, two companies with very different assets and liabilities could look identical if you relied on their working capital figures alone.
- Company A has current assets of £1 million and liabilities of £500,000.
- Company B has current assets of £5 million and liabilities of £4.5 million.
Both companies have a working capital (assets - liabilities) of £500,000, but Company A has a working capital ratio of 2, whereas Company B has a ratio of 1.1.
What is a good working capital ratio?
A higher ratio means there’s more cash-on-hand, which is generally a good thing. A lower ratio means cash is tighter, so a slowdown in sales could cause a cash flow issue.
Generally speaking, a ratio of less than 1 can indicate future liquidity problems, while a ratio between 1.2 and 2 is considered ideal. If the ratio is too high (i.e. over 2), it could signal that the company is hoarding too much cash, when it could be investing it back into the business to fuel growth.
What is the working capital requirement
Many businesses incur expenses before receiving money back from sales. This time delay between when your business pays money out (e.g. to suppliers) and when it receives money back (e.g. from sales) is known as the working capital or operating cycle. The working capital requirement of your business is the money you need to cover this time delay.
The working capital cycle formula is:
Inventory Days + Receivable Days - Payable Days = Working Capital Cycle in Days
You can read more in our article about how to work out your working capital cycle.
What is negative working capital?
Negative working capital is when a company’s current liabilities exceed its current assets. This means that there is more debt than assets available to pay it off. Before this happens to your business, there are steps you can take to increase working capital.
What’s the difference between working capital and cash flow?
Working capital might sound the same as cash flow (both figures reflect your business’s financial state), but there is a key difference. Cash flow offers a snapshot of the money moving into and out of your business at a given point in time while working capital considers liabilities and assets that will have an impact on your business across the financial year.
Unlike working capital, cash flow doesn’t reveal how effectively you’re managing your finances or how much leeway you’ll have if you run into problems with your supply chain, for example.
Because working capital considers money coming in (accounts receivable) and money you owe (accounts payable) alongside other liabilities, it provides a clearer idea of how well-equipped you are to ride out unforeseen storms, as well as pay your debts, outgoings, and payments.
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Importance of using the working capital formula
Not only does the working capital formula consider cash flow and operational efficiency, but it also measures current asset liquidity to cover short-term liabilities, ensuring obligations can be met. This, in turn, is crucial for evaluating the financial feasibility of growth initiatives or investments.
Another important benefit of understanding your working capital is that it’s often used as a measure of a company's financial health and creditworthiness. Lenders, investors, and suppliers look at a company's working capital to assess its ability to meet financial obligations. A healthy working capital position demonstrates that a business is well-managed and capable of meeting its financial commitments. This can instil confidence in stakeholders and improve access to credit or investment opportunities.
Other working capital calculations
The working capital formula is one of the essential accounting formulas that every business owner should know, and there are several variations to it that are also useful depending on how you are trying to determine the health of your business.
Net working capital formula
Net working capital (NWC) is almost always used interchangeably with working capital.
However, some analysts define NWC more narrowly to provide a more comprehensive picture of a company's health. In this case, the formula excludes cash assets and debt liabilities:
Net Working Capital = Current Assets (Minus Cash) - Current Liabilities (Minus Debt)
Some define it even more narrowly, excluding most types of asset, to give the most comprehensive picture:
Net Working Capital = Accounts Receivable + Inventory - Accounts Payable
Operating working capital formula
Operating working capital, also known as OWC, helps you to understand the liquidity in your business. While net working capital looks at all the assets in your business minus liabilities, operating working capital looks at all assets minus cash, securities, and short-term, non-interest debts.
OWC is useful when looking at how well your business can handle day-to-day operations, while knowing how to work out NWC is useful in considering how your company is growing.
The operating working capital formula is:
Operating Working Capital = Current Assets – Non-operating Current Assets
Non-cash working capital formula
Knowing the difference between working capital and non-cash working capital is key to understanding the health of your cash flow and the liquidity of your current assets and obligations.
Non-cash working capital (NCWC) is the difference between current assets excluding cash and current liabilities. This can also be expressed as net working capital minus cash.
The formula to calculate non-cash working capital is:
Non-cash Working Capital = (Current Assets – Cash) – Current Liabilities
Change in working capital formula
Change in working capital refers to the way that your company’s net working capital changes from one accounting period to another. This is monitored to ensure that your business has sufficient working capital in every accounting period, so that resources are fully utilised, and to help protect the company from experiencing a shortage in funds.
The formula to calculate change in working capital is:
Change in Working Capital = Working Capital (Current Year) – Working Capital (Previous Year)
It can also be expressed as:
Change in Working Capital = Change in Current Assets – Change in Current Liabilities
List of working capital formulas
- Working capital = current assets – current liabilities.
- Net working capital = current assets (minus cash) - current liabilities (minus debt).
- Operating working capital = current assets – non-operating current assets.
- Non-cash working capital = (current assets – cash) – current liabilities.
- Change in working capital = working capital (current year) – working capital (previous year).
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