What is working capital and why is it important?

What is working capital?

Imagine working capital as the driving force of any business, powering a company’s day-to-day operations. But technically speaking, working capital is the difference between current assets and current liabilities.

The resulting number provides insight into a company's ability to meet short-term financial obligations, including:

• Paying bills
• Payroll
• Maintaining inventory and supply levels
• Covering other necessary operating expenses
• Investing in growth opportunities

How to calculate the working capital ratio within your business

The formula for your working capital ratio is simple: Divide your company's current assets by its current liabilities.

Let's say an ecommerce store has $50,000 in assets and $25,000 in liabilities. The store's working capital ratio would be 2.

Working capital = $50,000 / $25,000 = 2

To calculate the net working capital, subtract all current liabilities from all current assets. In this example, the store would have $25,000 in working capital readily available.

The working capital ratio can be helpful in providing insights into your company's liquidity and operational efficiency. However, the ideal ratio can vary depending on the industry and a company’s circumstance.

Typically, a working capital ratio of 2:1 or higher is considered ideal, indicating that a company has enough current assets to cover its current liabilities twice over. A working capital ratio below 1:1 is generally considered low and could be a red flag for investors or creditors.

Low working capital

If the working capital ratio is less than one, it means the company's current assets may not be enough to cover its current liabilities.

In other words, it suggests the company may be facing financial difficulties in the short term, such as struggling to pay bills, meet payroll, or make other necessary payments.

High working capital

A high working capital ratio means a company has a surplus of current assets compared to its liabilities.

If the result is significantly higher than two, it suggests the company may be holding more cash than it needs, which may be better spent on growth and investment opportunities.

Components of working capital

The main components of working capital are typically listed on a company’s balance sheet. Some of the biggest line items include:

• Cash and cash equivalents, including all liquid cash and any short-term investments that can be easily converted into cash.
• Accounts receivable. The money a company is owed by customers but has not yet been collected.
• Accounts payable. The money a company owes to its suppliers but has not yet been paid out.
• Accrued expenses. Any expenses a company has incurred but has not yet paid, such as wages, rent, and utilities.
• Inventory. The value of all products a company has in stock and is ready to sell.
• Interest payable on loans as well as loan principal due within one year.

Current assets

Current assets are either cash or can be quickly converted into cash within a year or less. Examples that may appear on a balance sheet include:

• Cash and cash equivalents
• Accounts receivable
• Inventory
• Prepaid expenses
• Short-term investments

Current liabilities

Current liabilities refer to a company's financial obligations that are due within one year or less. Examples that may appear on a balance sheet include:

• Accounts payable
• Short-term loans
• Taxes payable
• Unearned revenue
• Accrued expenses

Why might your business require additional working capital?

Working capital can help keep your operations running smoothly and allow you to invest in growth. But there may also be other times when your business requires more capital.

Some of those instances could be:

• Paying bills and/or unanticipated expenses
• Managing inventory
• Managing busy seasons, such as during the holidays
• Taking advantage of an unexpected business opportunity

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