Every small business has some level of working capital, but if you’re unsure of what it is and how it’s calculated, we have you covered. In simple terms, working capital can also be referred to as net working capital. It’s the difference between a company’s current assets like what cash they have, accounts receivable/customers’ unpaid bills, and inventories of materials and finished goods — and its current liabilities, like accounts payable and debts.
How to Calculate Working Capital
Working capital is calculated by dividing the total current assets by the total current liabilities (including long-term and short-term liabilities). This business tool helps companies make the most effective use of their current assets and maintain a sufficient cash flow to meet short-term goals and other obligations. A company’s working capital can also determine if the company has enough cash to sustain its operations and the amount of working capital can also determine a company’s long and short-term financial health.
Positive working capital means the company can pay its bills and also make investments to stimulate the growth of its business. Negative working capital means that the company’s current liabilities exceed its assets and it has more short-term debts than short-term assets.
Working Capital Formula
The working capital formula is simple and will always be calculated as follows:
Working capital calculation: Working capital = Current assets – Current liabilities
Current Assets include cash and accounts receivable, while current liabilities include accounts payable (AP).
There are other important working capital metrics to keep in mind which include:
- Days Payables Outstanding (DPO): The average number of days that the company takes to pay back accounts payable. It measures how well the company manages its AP. For example, a DPO of 30 means that the company takes 30days to pay back its suppliers. It is calculated like this:
Accounts payable X Number of days/Cost of goods sold (COGS) = DPO
- Days Sales Outstanding (DSO): The average number of days taken for customers to pay their invoices, typically showing an issue with their cash flow. It’s used to determine how effective a company’s credit and collection efforts are in offering credit to its customers, in addition to its ability to collect from them. It is calculated like this:
(Accounts receivable ÷ annual revenue) × Number of days in the year = DSO
- Days Inventory Outstanding (DIO): The average number of days that the company holds inventory before they sell it. This ratio shows how quickly a company can turn its inventory into cash. The formula is as follows:
DIO = (Average inventory / Cost of sales) x Number of days in the period
- Cash Conversion Cycle (CCC): This process is when a company purchases inventory, sells the inventory on credit as accounts receivable, then collects the accounts receivable. CCC can also be referred to as the “net operating cycle” which measures the average number of days it takes a company to purchase inventory and turn that inventory into cash.
CCC is calculated by:
DIO + DSO – DPO = CCC
Working Capital Ratio
The working capital ratio is a measure of liquidity or the ease of an asset to be converted into cash without changing its market price (liquid assets). The ratio shows whether a business can pay its obligations such as debts, advances, etc. The ratio shows whether or not your business has the ability to pay for its current liabilities with the current assets available. So whether it’s short-term or long-term debt, do your business’s current assets cover the debts?
What Does the Working Capital Ratio Mean?
The working capital ratio formula shows the ratio of assets to liabilities. This means how many times a company can pay off its current liabilities with its current assets which are based on the working capital ratio: Working capital ratio = Current assets / Current liabilities.
Knowing the ratio is important because relying on working capital alone would make two companies with very different assets and liabilities look identical. In addition, a higher ratio means that there’s more cash on hand, while a lower ratio shows that cash is much tighter and indicates a cash flow issue.
Working Capital vs. Net Working Capital
You may find that “working capital” and “net working capital” are synonymous. Both of the terms identify differences between all current assets and all current liabilities.
However, although they are often used interchangeably, some analysts use this formula for “net working capital”:
Net working capital = current assets (less cash) – current liabilities (less debt)
An additional definition of net working capital excludes most types of assets and closely focuses only on accounts receivable, accounts payable, and inventory.
Net working capital = accounts receivable + inventory – accounts payable
Elements Included in Working Capital
There are three main components of working capital which include:
- Accounts payable (AP)
- Account receivables (AR)
- Current assets (inventory, cash, cash equivalents, etc.)
Cash, AR, and inventory are typically found in your company’s current assets column. AP is considered a liability.
How Working Capital Affects Cash Flow
Cash flow represents every amount of cash that comes in and goes out of your business. Working capital is more of a company’s balance sheet of the financial statement. Working capital and cash flow work together to provide a fuller picture of your company’s operating finances — showing micro and macro-level financial analysis.
Cash flow can include:
Any changes in a company’s working capital are reflected in its cash flow statement. Here’s a working capital example that shows its effect on cash flow:
If a company received cash from a short-term debt like a line of credit or a short-term loan that is set to be paid within 60-90 days, the business would see an increase in the cash flow statement. However, the working capital would not indicate any increase because the money from the loan would be classified as a current asset or cash. The short-term loan or debt would then be a current liability.
Another example would be:
Your company purchases a brick and mortar. As a result, your cash flow would immediately decrease since you used cash (current assets) to make the purchase. However, your current liabilities would not change because this is considered a longer-term debt.
The Importance of Understanding Your Working Capital
Simply put, your business needs and relies heavily on working capital in order to operate. Understanding your working capital helps in three main areas:
- Knowing the direction of the company’s investments
- Identifying the liquidity of the company’s assets
- Influencing negotiations with suppliers and vendors
What is Working Capital Management?
The purpose of working capital management is to ensure you are on the right track with your company’s liquidity. When you have insufficient working capital, this causes a domino effect such as the inability to meet obligations when due and leads to late payments to creditors, employees, and suppliers. Without working capital management your business can end up with damaged credit, an untrusted supplier relationship, and employee attrition.
In addition to liquidity, working capital management focuses on a company’s profitability. Working capital doesn’t always equate to funds earning a return. As a result, working capital management’s role is to ensure the company is not doing two things:
- Overtrading: This is insufficient working capital to support the level of business activities.
- Over-capitalization: This is an extreme level of working capital that leads to inefficiency.
Essentially, working capital management is important because it ensures that you are using your company’s resources more effectively by monitoring then optimizing the use of current assets and liabilities. In addition to educational tools, Nav’s marketplace for finding the best financing for your business can certainly help your working capital work for you.
This article was originally written on April 14, 2022 and updated on April 20, 2022.