Working Capital Formula (Definition, Components and How to)
By Indeed Editorial Team
Published 15 November 2022
The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.
Working capital is a term that describes the finances that are necessary for businesses to continue their everyday operations. It allows businesses to pay staff, place orders, pay rent and make payments on company loans. Learning how to calculate the working capital might help you better evaluate a company's financial health. In this article, we define the working capital formula, explain the techniques of managing working capital, highlight the steps to calculate it and provide an example to guide you.
What is the working capital formula?
The working capital formula refers to the principle a company can use to determine its accessible finances for day-to-day operations. It's the sum of a company's current assets minus its current liabilities. The availability of working capital indicates a company's solvency and capacity to make debt repayments and run smoothly.
Working capital helps you determine how liquid a company is and if it can pay off its debts quickly, typically within a year. It's a reliable measure of a company's financial health since it demonstrates to investors what can happen if it uses its current assets to repay its obligations. The formula determines a company's cash accessible for daily expenditures. Companies use this formula to compare costs to present capital resources and accurately assess the company's funds. Here's the formula:
Working capital = Current assets - Current liabilities
Types of assets and liabilities
The first step in calculating a company's working capital is taking stock of its current assets and liabilities. Here are some typical types of assets and liabilities that may help you better understand the financial health of a business:
Examples of current assets
Here are some assets that businesses evaluate when determining working capital:
Cash on hand: Cash on hand refers to accessible funds in a company's bank that it can obtain readily and promptly.
Liquid assets: These are any assets that a corporation can readily and rapidly convert to cash if required, including stocks or government bonds.
Accounts receivable: These are any payments a business anticipates from customers or other companies, such as a pending service invoice.
Inventory: Any product inventory a corporation has in its warehousing or other locations is an asset.
Short-term investments: Companies see short-term investments that can provide a financial return soon as assets.
Examples of current liabilities
These are some of the most typical liabilities that businesses consider when determining working capital:
Accounts payable: This refers to any monies that the business owes in the short term. For example, a corporation may owe a payment to a supplier for manufacturing supplies.
Bank overdrafts: If the business overdraws its bank accounts, it may be liable for overdraft costs besides the overdrawn total.
Payroll: An organisation's payroll is a recurring and variable financial obligation.
Income taxes: A business pays taxes on reported profits and considers these costs a liability.
Rents and overhead: Overhead expenditures include expenses such as rent and utility bills that businesses pay monthly.
Short-term loans: Businesses consider any short-term loans or lines of credit as obligations.
Outstanding costs: Any outstanding expenses incurred by a corporation are liabilities it can cover with the working capital.
Working capital management techniques
An effective way to manage a company's working capital is to maintain appropriate levels of both assets and liabilities. Here are several techniques for working capital management that financial managers can employ:
Evaluating the balance sheet can reveal chances for boosting assets or reducing liabilities to improve a company's working capital. Examining a company's previous balance sheets may assist financial managers in determining the bare minimum of cash necessary to cover daily operating expenditures. It may also be helpful to eliminate unnecessary expenses through cost-cutting or expense reduction.
Some businesses can explore bargaining with vendors to get reductions or better rates from them.
Financial managers may look at the company's and its clients' credit policies or conditions. A favourable credit strategy can attract new consumers while increasing cash flow. Reviewing unrecoverable receivables or bad credit may be helpful for organisations that provide credit.
These companies may minimise their bad debts by selling more high-margin products or altering the margins on their current offers.
Finding finance solutions that better match the company's unique requirements and offer lower interest rates can assist businesses in increasing working capital. To help manage working capital, companies can negotiate with their banks to extend repayment periods or change other particular aspects of their financing. Financial managers can also avoid using working capital to finance fixed assets, such as property, plant and equipment.
Companies may find it helpful to finance these acquisitions through long-term loans or leases.
Businesses may boost working capital by determining the optimal inventory levels and reducing the quantity of unsold goods on hand. They can save money on raw materials by analysing delivery schedules. Some companies may lower their operating cycle and increase their working capital by reviewing credit terms or requesting payment before the delivery of goods.
By implementing these adjustments, companies may free up more money, improving their cash flow.
How to calculate working capital
Follow these steps to understand how to apply this financial formula:
1. Identify current assets
Determine the existing assets accessible to the company and add them together to get a reasonable estimate for your formula. For example, you may discover the corporation has around $500,000 in current assets and $25,000 in cash, so include things like inventory on the list.
You may total up all of your assets using accounting software or a spreadsheet. Once you've determined the total assets accessible to the company, enter that figure into the formula's current financial assets field.
2. Identify current liabilities
Once you've identified your financial assets, you can calculate the current liabilities to finalise the formula. Calculate the sum of each of your liabilities after determining how many to include in the formula. Then sum them all together to get your overall business obligations.
This figure is usually lower than your assets if you have a solid working capital ratio. If your spending exceeds your assets, the formula produces a negative figure, indicating how much the organisation owes in liabilities.
3. Subtract liabilities from current assets
Subtract your liability amounts from your assets to complete your calculation. This yields a figure that might serve as your working capital. Using the values above, for example, produces a working capital of $150,000.
The business has $150,000 in available capital and can effectively pay its day-to-day costs and emergency needs. If you get a negative figure after you finish your calculation, double-check your initial estimates and then go through the company's financial records to identify the discrepancy between spending and assets. Here's what the calculation looks like:
Working capital = $500,000 - $350,000
4. Calculate your working capital cycle
You may calculate the working capital cycle after you've determined your working capital. A working capital cycle is the period that passes between the company's outgoing expenditures and receiving payments, which might impact your working capital. The working capital cycle has its formula, which is:
Working capital cycle = Receivable days + Inventory days - Payable days
Understanding this time lag allows you to calculate the amount of capital necessary to bridge the gap. For example, if your inventory cycle is 56 days and your receivable cycle is 31 days, with 23 payable days, the working capital cycle is 64 days. You need working cash to meet your expenditures for the next 64 days.
Example of calculating working capital
To establish a company's financial health, the ability to swiftly identify data and compute business working capital is vital. Here's an example to help you understand how to calculate working capital:
Sip and Fizz Beverage Co.
A beverage company is estimating its working capital. They begin by gathering all their data to enter it into the formula. After evaluating its assets, which include a current account for $620,000 and goods worth $250,000, they now have $870,000 in assets.
After calculating its obligations, which include $30,000 in rent, $12,000 in total utilities, $21,000 in materials and debt payment of $75,000 due in one year, they now have $138,000 in liabilities. They may now determine their operating capital and its ratio:
Current working capital = $870,000 - $138,000
Current working capital = $732,000
Current working capital ratio = $870,000 / $138,000
Current working capital ratio = 6.3
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