What is the working capital formula?
Working capital is crucial for any business, and using the working capital formula is a simple way to see how a company is performing. Before we look at the formula, let’s delve into the subject of working capital.
Definition of working capital
Businesses need working capital to pay employees, as well as cover ongoing expenses and operating costs, such as paying rent and utilities. Working capital is calculated by subtracting current liabilities from current assets.
When you understand working capital (sometimes called ‘net working capital’), you can plan for sustainable growth and meet future expenses.
The components of working capital
The components used to calculate working capital are current assets and current liabilities:
Current Assets: This includes cash and cash equivalents, marketable securities, inventory and accounts receivable. Assets that a company owns that can be converted into cash within 12 months also fall under this category.
Current Liabilities: Money the business owes in the form of the accounts payable, accrued expenses, and short-term loans that are due within a year fall under this category. Long-term debt is not classified as a current liability.
Calculating the working capital ratio
Here’s the net working capital formula used to calculate the working capital ratio:
Working Capital = Current Assets – Current Liabilities
This working capital ratio formula shows how much short-term liquid assets you have after paying off the short-term liabilities. It measures short-term liquidity and is used in financial modelling, financial analysis, and cash flow management. This formula is considered to be the broadest, since it includes all the accounts.
There’s another formula that’s not as broad and only includes three accounts:
Net Working Capital = Accounts Receivable + Inventory – Accounts Payable
For an in-depth overview, check out What is Working Capital and Why Is It Essential for Your Business?
Example of net working capital
Here’s an example of the balance sheet that will indicate how to derive the net working capital (NWC):
Current Assets
Cash: $30,000
Inventory: $50,000
Accounts Receivable: $25,000
Total: $105,000
Current Liabilities
Accrued Liabilities: $20,000
Accounts Payable: $25,000
Short-term Borrowings: $3,000
Total: $48,000
Using the working capital formula, we subtract current liabilities from current assets:
Working Capital = $105,000 (current assets) – $48,000 (current liabilities) = $57,000
If we use the other working capital formula, which is sometimes used by business lenders, working capital will be:
Net Working Capital = $25,000 (Accounts Receivable) + $50,000 (Inventory) – $25,000 (Accounts Payable) = $50,000
Positive working capital
If a company has positive working capital, it’s a good sign. It shows that the business is doing well and has enough liquid assets to pay any short-term obligations such as short-term debt and bills. The example above shows that the company has a positive working capital.
Here’s another example that shows the positive working capital in a balance sheet.
The ABC company has the following current assets and liabilities:
Current Assets
Cash: $30,000
Inventory: $ 20,000
Accounts Receivable: $5,000
Total: $ 55,000
Current Liabilities
Accrued Liabilities: $22,000
Accounts Payable: $25,000
Short-term Borrowings: $3000
Total: $50,000
In this example:
Net Working Capital (NWC) = $55,000 (Total Assets) – $50,000 (Current Liabilities) = $5,000.
Negative working capital
Negative working capital indicates that a company is not using current or fixed assets effectively. Here’s an example:
Current Assets
Cash: $10,000
Inventories: $ 20,000
Accounts Receivable: $5,000
Total: $35,000
Current Liabilities
Accrued Liabilities: $15,000
Accounts Payable: $25,000
Short-term Borrowings: $5,000
Total: $45,000
In this example:
Net Working Capital (NWC) = $35,000 (Total Assets) – $45,000 (Current Liabilities) = –$10,000.
This situation will eventually damage the credit rating of the business, especially if it ends up borrowing more money or when it’s late in paying suppliers and creditors.
In some cases, negative working capital is perfectly okay. For example, high-volume retail businesses such as Woolworths and Coles. Although they may have negative working capital, they can raise large amounts of capital to cover temporary shortfalls. This is possible because of the quick turnover rates of the vast inventory that they hold in their stores. They are in a position where they can sell products before they need to pay the suppliers and vendors. So while they might have negative working capital at times (as a result of their accounts payable), they are constantly selling inventory to boost their cash.
In contrast, companies that manufacture things like machinery and equipment need large amounts of working capital as there are large time gaps between creating products and receiving revenue from selling them. These types of issues can be analysed using the working capital formula.
Unsecured business loans are one option to overcome negative working capital.
