Working capital is one of the most essential measures of a company’s success. To operate your business effectively, you need to be able to pay off short-term debts and expenses when they become due. This requires liquid assets, or working capital.
The Net Working Capital Formula and the Working Capital Ratio Formula are the easiest ways to determine whether your business has the cash flow necessary to meet your debt and operational demands over the next year. To be considered “current”, these liabilities and assets must be expected to be paid or accessible within one year (or one business cycle, whichever is less).
Current liabilities
Tally up all the debts, expenses, and other financial obligations expected for your business throughout the year or your operating cycle.
Examples of current liabilities include:
- Outstanding bills (accounts payable to vendors, suppliers, utilities, etc.)
- Mortgage, lease, or rent payments
- Other loans due within 12 months
- Wages to be paid in the next year
- Dividends payable to investors
- Interest and fees on loans
- Income taxes owed within the next year
Other current liabilities vary depending on your occupation, your industry, or government regulations. In addition to business licenses and permits, some practitioners require annual licensing or continuing education. For example, individual architects in all 50 states require licenses with regular renewals. So do many engineering, construction, financial services, insurance, healthcare, dental, and real estate professionals. Be sure to include these expected expenses in your working capital formula.
Current assets
Generally speaking, an asset is anything of financial value that your company owns. These can be tangible or intangible. However, for an asset to be considered current or liquid, it must be something that can be easily and quickly exchanged for cash in the short term.
Examples of current assets include:
- The value of your inventory
- Accounts receivable
- Stocks, bonds, mutual funds, and ETFs (that will be liquid within the next year)
- Money market accounts
- Checking and savings accounts
- Cash and cash equivalent
- Shorter-term, prepaid expenses
- Current assets of discontinued operations
- Interest payable
Current assets do not include long-term financial investments or other holdings that may be difficult to liquidate quickly. These include land, real estate, and some collectibles, which can take a long time to find a buyer for.
Net Working Capital Formulas
To calculate your business’ net working capital (NWC), also known as net operating working capital (NOWC), subtract your total current liabilities from your total current assets. Depending on how detailed you or your analyst wants your working capital calculation to be, you can choose from one of several different models.
The most complete formula includes all accounts:
- For simplicity sake, some businesses prefer a more narrow calculation:
Current Assets (less cash) – Current Liabilities (less debt) = Net Working Capital Some even choose a formula that uses only three accounts:
Accounts Receivable + Inventory – Accounts Payable = Net Working Capital- Some even choose a formula that uses only three accounts:
Accounts Receivable + Inventory – Accounts Payable = Net Working Capital
Net Working Capital Formula Example
For a sample calculation of net working capital, take a look at the following simplified list of current assets and liabilities:
Current Liabilities:
Accounts Payable: $17,500
Accrued Expenses: $12,500
Other Trade Debt: $35,000
Total Liabilities: $65,000
Current Assets:
Cash: $30,000
Accounts Receivable: $40,000
Inventory: $20,000
Total Assets: $90,000
By subtracting the total Current Liabilities ($65,000) from the total Current Assets ($90,000), you can see this company’s current assets exceed their current liabilities, yielding a positive working capital of $25,000. This indicates that the company is very liquid and financially sound in the short-term. If this company's liabilities exceeded their assets, the working capital would be negative and therefore lack short-term liquidity for now.
Working Capital Ratio Formula
Alternatively, you can calculate a working capital ratio. This is done simply by dividing total current assets by total current liabilities, to get a ratio such as 2:1 (twice as much in assets) or 1:1 (equal assets and liabilities).
Current Assets ÷ Current Liabilities = Working Capital Ratio
Using figures from the example above, the working capital ratio for the company would be 1:3.
Working Capital Requirement Formula
If your business works with suppliers, another helpful metric to know is your working capital requirement. This is the amount of money you need to buy goods or raw materials from suppliers and either hold them as inventory or use them for manufacturing in order to sell to customers. By providing a monetary indicator of supply and demand, this formula can help you adequately plan for (and have financing in place to deal with) an increase in sales, without running out of the cash needed to obtain the products or materials to satisfy growth.
Inventory + Accounts Receivable – Accounts Payable = Net Working Capital Requirement
Why Your Business Should Calculate Working Capital
Measuring its liquidity can give you a quantitative assessment of your business’ timely ability to meet financial obligations, including paying your employees, your suppliers, and your bills. This provides an honest picture of the company’s short-term financial health.
Positive vs Negative Working Capital
Generally speaking, the higher your net working capital or working capital ratio is, the greater will be your company’s comfort level to absorb future planned or unexpected expenses and your ability to grow. For example, while a working capital ratio of 2:1 usually provides a healthy cash buffer, a ratio of less than 1:1 indicates that you may have difficulty paying bills.
However, a conspicuously high positive net working capital or ratio may not be a good thing either, because it could indicate an overstock of inventory or that your capital is sitting idle instead of being invested in company growth.
If your business’ net working capital is just a little above equal or your capital ratio falls somewhere between 2:1 and 1:1, your company health may depend on how quickly you can access liquid cash — either through selling your inventory or collecting on outstanding invoices. You could also turn to financial tools such as invoice financing or a business line of credit to augment your short-term working capital.
If you have a long business cycle (meaning it takes a while to sell your products or services and collect receivables), you should think about targeting a higher net working capital or working capital ratio to ensure the health of your business. Many industries — like construction, travel and tourism, and some retail operations — typically face seasonal differences in cash flow. In these cases, you may need to plan for ensuring extra capital during leaner times.
Is negative working capital OK for your business?
Usually, having negative working capital is not a positive. However, what’s more important is the reason it’s negative. It’s not necessarily a bad thing. There are some situations or types of companies in which you may face more short-term liabilities than you have short-term assets and it could still work in your favor (if managed properly).
Negative working capital can work out for the best if it happens when a company funds its sales growth using other people’s money — essentially going into debt with its customers or suppliers. Here are two scenarios:
- Companies whose revenue is based on subscriptions, longer-term contracts, or retainers (such as publishers, advertising agencies, and some professional services companies like law firms) often have negative working capital because their revenue balances are often deferred.
- Cash-up-front businesses, like many retailers, grocery stores, and restaurants, often have negative working capital because they use the cash to pay off their Accounts Payable rather than keeping liquid capital on hand. For example, if your customer pays by credit card before you have to pay your vendors for the product, this can improve your business’ efficiency and can save you from paying interest on bank financing.
Generally speaking, however, shouldering long-term negative working capital — always having more current liabilities than current assets — your business may simply not be lucrative.
Change in Working Capital Formulas
It can also be helpful to calculate the change in net working capital of your business from the one accounting period and compare it to another accounting period. This comparison can help you predict a future issue — such as your funds either falling short or sitting idle. Here are three common formulas for calculating the change:
Working Capital (Current Period) – Working Capital (Previous Period) = Changes in Net Working Capital
or
Change in Current Assets – Change in Current Liabilities = Change in a Net Working Capital
The answer may be counterintuitive, because a negative change indicates that Current Assets are increasing more than Current Liabilities. Conversely, a positive change indicates that Current Liabilities are outpacing Current Assets.
The Bottom Line
Calculating your working capital is a quick way to gain an overview of your business’ cash flow. It’s important to look not at just at the numbers, but to examine the reason behind the numbers, and to analyze whether it’s from a short-term or long-term event, or just due to what’s most efficient for your type of business.
- If you have a positive cash flow, your liquid assets are increasing, letting you pay your debts and expenses, invest in growth, or help cushion against future challenges. However, a positive answer could also indicate too much inventory or too limited growth.
- If you have a negative cash flow, you may not be generating enough revenue to stay liquid, perhaps from spending too much on capital expenditures or having too much profit tied up in accounts receivable, a common downside of offering trade credit. On the other hand, if your business is low on working capital because you primarily get cash up front, or you’re investing your revenue in long-term fixed assets that will pay off big in the future, then that can be a good thing.
The success or failure of your business depends heavily on your ability to use your assets effectively (and even your indebtedness) effectively, and calculating your working capital, whichever formula you use, can give you the insight to know what’s working or what’s not.
Disclaimer: Fundbox and its affiliates do not provide financial, legal or accounting advice. This content has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for financial, legal or accounting advice. You should consult your own financial, legal or accounting advisors before engaging in any transaction.