There are a lot of meanings for the word capital — as a letter, a city, an old fashioned British exclamation.
Even just in the field of business, capital comes in many forms.
For instance, entrepreneurs are familiar with startup capital, which is the money needed to get their idea off the ground.
Human resource managers are more concerned with human capital, or the economic value that employees bring to an organization.
Those who want to know the current financial condition of a company, however, should be most concerned with working capital.
If capital is the money or wealth of a business, then working capital is the money or wealth the business actually has to work with — the amount it has available and on hand for its daily operations.
This post explains how to calculate working capital, why it’s important, and the simple changes that can create a more positive result for the company.
What Is Working Capital?
Working capital is a key financial metric that indicates how much available capital a business has at any given time.
By looking at only the assets and liabilities — what’s on hand and not tied up in investments or other fixed assets — it determines whether a business has enough to meet its day-to-day needs.
Working capital is a simple yet crucial piece of information.
Knowing how much a business has access to (a.k.a. how liquid it is) reveals a lot about the way it operates and how healthy it is financially.
This is important not only to business owners, but to investors and creditors, as well.
If a business has positive working capital, it can capably cover its operating costs (i.e., salaries, rent, supplies), and look forward to growth in the future.
Negative working capital, on the other hand, indicates that the business may have problems paying for its expenses or obligations, and should consider changing the way it operates.
Types of Working Capital
Working capital can either be based on value or time.
Value-based working capital can further be divided into gross working capital and net working capital.
Gross working capital is basically the total current assets of a business, while net working capital — what most people mean when referring to working capital — is the value of current assets left after deducting current liabilities.
Time-based working capital takes peak and low seasons into consideration, and is usually either permanent or temporary working capital.
The permanent or fixed variety is what a business needs to operate regardless of external forces.
Of course, this will change during times of expansion or slowdown, but for the most part, it’s the minimum amount required for continued business.
Temporary or variable working capital greatly depends on production and sales.
(For example, a pool company may experience increased revenue during the spring and summer season.)
Whether it’s a change in seasons, a shift in market demand, or other external factors, temporary working capital is any amount aside from the permanent working capital needed to accommodate these fluctuations.
How to Calculate Working Capital
To calculate working capital, you’ll need to know your current assets and current liabilities (these are usually found on a business’s balance sheet).
Assets are any resources a business owns that has economic or monetary value, such as cash, cash equivalents, accounts receivable, inventory, supplies, or equipment.
Current assets, or short-term assets, are those that can be expected to convert to cash within one year.
Conversely, liabilities are any financial debts or obligations that a business is responsible for, typically incurred during the course of operations.
These include loans, mortgages, accrued expenses, notes payable, accounts payable, or salaries payable.
Current liabilities, or short-term liabilities, are those that a business expects to settle in cash within one year.
The calculation for working capital is simply the difference between current assets and current liabilities.
The working capital formula is as follows:
Current Assets – Current Liabilities = Working Capital
For example, say a pet food company has $7,000 in cash, $15,000 in savings, $20,000 worth of inventory (projected to be sold this year), and $750 in accounts receivable.
It also has $15,000 in loans ($10,000 of which it has to pay this year), $5,000 in salaries payable, and $3,500 in accrued expenses.
This company’s current assets are $42,750 ($7,000 + $15,000 + $20,000 + $750), and its current liabilities are $18,500 ($10,000 + $5,000 + $3,500).
Therefore, its working capital amounts to $24,250 ($42,750 – $18,500).
Take another example of a sole proprietorship that has $100 in cash and $200 in accounts receivable.
It also has $50 in short-term debt and $150 in accounts payable.
This reveals the sole proprietor’s current assets are $300 ($100 + $200) and its current liabilities are $200 ($50 + $150).
Still, a positive working capital of $100.
However, if the accounts payable is due this week but the accounts receivable isn’t received until next week, then the sole proprietor is still unable to pay their expenses.
So although working capital provides a more accurate picture than most balance sheets or formulas, a positive number still doesn’t guarantee that a business will have the cash to cover its expenses — only that it has a positive operating liquidity.
Other factors, such as the type of current assets or the method of received payments, also play a role in how comfortably a company can operate.
How to Calculate for Working Capital Ratio
Another way to gauge working capital is by calculating for its ratio.
This uses the same elements, but instead of taking current assets and subtracting current liabilities, it divides current assets by current liabilities.
In the above two examples, the working capital ratio would amount to 2.3 for the pet food company, and 1.5 for the sole proprietorship.
Financial ratios are sometimes easier to work with, as they allow for easier analysis.
A working capital ratio of one shows that current assets equal current liabilities, which indicates a break-even status.
Anything below one is considered high risk, especially for potential investors or creditors.
Of course, anything above one is considered much better, although it’s best to keep the current ratio between 1.2 to 2.
Too much working capital may indicate that the business is holding on to a surplus of assets and may not be operating at an efficient level.
What a Company’s Working Capital Reveals
No matter the size of a business, working capital is a key indicator of its financial health and how well it’s doing.
For smaller outfits or startups, understanding working capital is important to keep track of operations and stay in business.
It reveals whether the business has enough money to pay short-term expenses or whether too much money is tied up in long-term assets.
For larger companies, a significant working capital is a good way to help secure a small business loan, a line of credit with the bank, or a potential investor.
It’s true that some businesses, such as grocery stores, buy-and-sell retailers, and electronics, may not need much working capital.
They usually experience such a high inventory turnover, that they receive and roll cash back into the business quite quickly.
(In fact, some may even sell their products before having to pay for them.)
In most cases, however, working capital indicates whether a business is actually able to pay for its expenses.
Regardless of how many fixed assets or other investments it may have, if the business doesn’t have enough working capital to pay its bills, this is a bad sign for the continued success of the company.
Ways to Improve Working Capital
You can improve your working capital by either increasing your current assets or decreasing your current liabilities.
You can increase current assets by increasing profits, managing inventory, and managing credit and debt.
For example, a business can identify its ideal amount of retained inventory and possibly send back any unsold inventory at the end of a defined term.
It can also negotiate for a longer accounts payable term with its suppliers or vendors (i.e., payments can be made after 60 days, rather than 30 days), as well as a shorter accounts receivable term with its customers (i.e., payments should be received in 30 days, rather than 60 days).
All these changes can effectively increase a business’s current assets and operational liquidity.
In addition, you can reduce your company’s total current liabilities by selling any unused assets or using saved investments or cash toward payables.
Are there any pieces of equipment that are rarely used in daily operations?
Would the business save money by renting a car when needed, as opposed to outright buying one?
Keeping an eye out for ways to lessen liabilities will help free up money and can result in positive working capital.
How Working Capital Works for You
Working capital is a measure of whether or not a company has enough current assets to pay off its current liabilities.
By only taking into account what a business has on hand (and disregarding anything it may own but currently doesn’t have access to), working capital is one of the best indicators that a business can pay for its own day-to-day operations.
In most cases, positive working capital is a sign that a business is being properly managed and enjoys a healthy cash flow.
If your company has positive working capital, it has a high potential for growth in the near future.
If you’re an entrepreneur wondering how your business is doing or just want to make sure you’re making a profit, calculating your working capital is a great and easy way to find out whether you’re on the right track.