We've broken it down to make it super simple to compute, to help you determine if your business is as healthy as you need it to be.
Calculating working capital.
The formula for calculating working capital is relatively simple – you just subtract what your business owes from what it owns. Or, to get technical:
And you can also get your working capital ratio by dividing your current assets by your current liabilities:
Your current assets include the tangible and intangible property your company owns that you can liquidate or turn into cash in less than a year. Your current liabilities are debts you'll need cash assets to pay within a year. Here's a chart for reference.
Depending on your industry, there may be other current assets or liabilities you should include when figuring out your available working capital. Speak with a qualified accountant in your industry to help you decide what else to consider.
Analyzing your working capital ratio to evaluate your business's financial health.
If you calculated a working capital ratio between 1.5 and 2.0, congratulations – you're operating your business optimally. Our advice: Keep it up.
If you calculated a positive working capital – anything above 1.0 – you're still doing great. But keep in mind there's also such a thing as having too much working capital (which can run you into different challenges when you apply for financing). We'll get into that in the next section.
If your working capital ratio is less than 1.0 – take it as a sign there's room for improving your company's cash flow. The most common areas to look into are:
- Operations. If you're not selling fast enough, you may have operational issues like not fulfilling orders efficiently, which can cause your working capital to drop.
- Your industry, target market, and pricing. Are you selling the right products to the right people at the right price?
- Accounts receivables. If you're selling well but not collecting accounts receivable fast enough, your cash flow also suffers, affecting available working capital. Consider streamlining your invoicing process so you can get paid faster.
What's "too much working capital"?
As the saying goes, too much of anything isn't a good thing – and that includes working capital. A working capital ratio above 2.0 can actually indicate your business has opportunity for operational efficiency. If you're feeling flush, see if there are any smart investments you can make to increase productivity or if there are new business opportunities to explore. And make sure you do this evaluation before seeking business financing. Having a working capital ratio above 2.0 could reflect negatively on your business skills with some lenders.
Our initial analysis: Acme Services has $15,500 of working capital meaning it'll have $15,500 remaining at the end of the year after paying all of their bills. This is a good sign - they have a solid ability to keep their business running for the next twelve months. But we're not drawing a final conclusion yet, let's find out if they're actually operating their business efficiently by looking into its working capital ratio.
Remember, you calculate your working capital ratio by dividing your current assets by current liabilities. In Acme Services' case, it's:
$30,000 / $14,500 = 2.06
Final analysis: With a positive working capital ratio well over 1.0, Acme Services has plenty of money to pay its debts over the next year and remain in business. Sounds like good news at first, but let's pause for a second. Remember when we said anything above a 2.0 may actually be too high? Acme Services' working capital ratio is at 2.06, which indicates there may be opportunities to reinvest money back into its business or it's not taking enough risks to maximize business revenue.
What about gross working capital and non-cash working capital?
Gross working capital is a measure of all your company's financial resources and only focuses on total current assets. It doesn't subtract current liabilities. What we talked about above – net working capital – offers you a deeper dive into your company's financial situation. It helps you determine if you can pay your short-term liabilities or debts and have money left over to expand.
Since gross working capital doesn't offer a complete financial picture on how your business is operating, it's better to draw your analyses based on your net working capital calculation.
On the other hand, sometimes it's more beneficial to use the "non-cash working capital formula" to determine a company's value. Non-cash working capital only considers the value of your business inventory and accounts receivable. Industry standards determine what yours should be. To calculate it, you subtract cash and all cash equivalents from your current assets. The formula for calculating non-cash working capital is:
Non-Cash Working Capital = Current Assets (Accounts Receivable + Inventory Value) – Current Liabilities (Accounts Payable)
Your working capital ratio provides clues about how profitably you're running your business. If yours is too high, you're probably not collecting receivables or selling inventory fast enough to convert assets into cash. If your non-cash working capital is too low, you're likely not generating enough revenue or using supplier or other credit to operate your business. Either way, speak with your accountant to identify any issues in your business that need addressing. And whether you have positive or negative working capital today doesn't indicate it'll stay that way tomorrow. Get a pulse on your working capital consistently and constantly to keep your business in good financial health.
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