In a 2019 Babson study of small businesses in America, it showed that a lack of access to working capital resulted in less investment in technology and equipment, reduced pay to employees, and difficulties expanding into new markets.
But if you can understand your working capital, you hold the key to improving your ability to reinvest in your business and tapping into new growth potential. Here’s what you need to know.
What is working capital?
Working capital—also known as net working capital—is a measurement of a business’s short-term financial health. Simply put, it indicates your liquidity or ability to pay your bills. You can find it by taking your current assets and subtracting your current liabilities, both of which can be found on your balance sheet.
A positive working capital shows a business holds more cash value than its short-term debts. These businesses have enough cash to pay off their debts with some left over to invest in the company. This shows lenders and investors that you are reliable in servicing your debts with the potential for growth.
A negative working capital shows a business owes more than the cash it currently holds. This is a red flag for both lenders and investors that would provide funding. But it should also signal to you that you need to start increasing your cash flow.
What is the formula for working capital?
The calculation for working capital is simple and all information can be found on your balance sheet. No balance sheet? You can still easily calculate your working capital on your own. But if you’re looking for a bookkeeping solution that can provide all your necessary financial statements with minimal input, Bench can help.
The formula for working capital is:
Working Capital = Current Assets - Current Liabilities
Since working capital is calculated by subtracting your current liabilities from your current assets, start by finding these two values.
Your current assets
You can think of your current assets as the cash you hold as well as any cash you have guaranteed coming in.
The four major types of current assets are:
• Your accounts receivable—any payments from your clients you haven’t received yet
• Your cash equivalents which includes cash held in bank accounts
• The value of any inventory you hold
• The value of any marketable securities such as common stock
These values are all listed on your balance sheet (if you have one). Otherwise, begin with your bank balances to see your cash levels. If you’re using an invoicing solution, you will be able to find any accounts receivable there. And any good inventory management software will provide you with the value of your inventory.
Your current liabilities
Your current liabilities are any short-term outstanding debts that you have to pay off within the next year.
**Some examples of current liabilities: **
• Your accounts payable—any outstanding payments you have for goods or services you’ve been given
• Your outstanding credit card balances
• Any outstanding wages payable
• The outstanding balance of any loans that mature within one year
• Any accrued liabilities such as income or payroll tax
To add up your liabilities, collect any unpaid invoices to find your outstanding accounts payable. You can find credit card and loan balances by logging into your online account with the provider. Refer to your payroll records for any outstanding wages or tax liabilities.
Once you have these values, finding your working capital value is a breeze. Subtract your current liabilities from your current assets and you’re done!
If you have a positive value, you hold more cash than your short-term debts meaning you have a high potential of growth from reinvesting in the business. Alternatively, you can afford to take on more short-term debt. But if you have a negative value, you owe more than you hold and it’s time to start looking at ways to increase your cash flow. Consider something like running a sale to fast track some revenue or look to refinancing your short-term debt to something longer term.
Further reading: What is Cash Flow and How Can You Effectively Manage It?
The working capital ratio
With your current assets and current liabilities, you can also calculate the working capital ratio (or current ratio). The working capital ratio is a similar calculation and another way of showing a business’s ability to cover its debts. Instead of subtracting your current liabilities from your current assets, you will be dividing your current assets by your current liabilities:
Working Capital Ratio = Current Assets / Current Liabilities
For your current ratio, a value greater than one corresponds with positive working capital and a value less than one corresponds with negative working capital.
The working capital cycle
Your working capital cycle is the amount of time it takes for you to convert your net working capital amount into cash. This can be found by taking the time in between when you have to pay your short-term debts and when you will receive outstanding accounts receivables.
For example, let’s say Shawna’s Shoes has $2,500 in outstanding accounts receivables on a 60 day payment deadline and $1,000 in accounts payable due in 30 days. The net working capital value would be $1,500 ($2,500 in accounts receivables minus $1,000 in accounts payable).
Her working capital cycle is the time in between paying her accounts payables and receiving her accounts receivables: 30 days. Her working capital cycle shows her she needs to budget for at least 30 days in between when she pays her bills and when she receives her payments.
You’ll want to minimize your working capital cycle. To start, you can shorten your payment terms for your outstanding receivables and try to extend the time before you need to service your debt.
The basics of working capital management
To get started on managing your working capital, start by tracking your current assets and current liabilities so you can always find the working capital value. Once you’re tracking it, try to always keep it positive. Look to bring down your current liabilities by paying down debt early or refinance short-term liabilities into longer terms. Maybe you can take on a longer term loan to cover some short-term accounts payables that have been adding up.
Then try to get on top of your working capital cycle. Consider shortening your payment terms and extending how long you have to cover your short-term liabilities. This will help you manage your cash flow and make sure you have minimal time in between paying for things like your cost of goods sold and receiving your revenue.
Bookkeeping and accounting 101
- Revenue Recognition: A Simple Guide
- What is Profit Margin? A Simple Introduction
- Do I Need a Business Bank Account?
- How to Read (and Analyze) Financial Statements
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