How To Calculate Working Capital?

The ability to finance operations is essential for a business to function properly, whether it is to pay for raw material purchases or employee salaries. As your company's "nest egg", working capital plays a crucial role here!

Maintaining positive working capital enables a business to remain solvent and flexible while meeting its short-term obligations. This blog explains how to calculate working capital and its importance.

What Is Working Capital?

Working Capital is the difference between the business's current assets and liabilities. Hence, business owners can use the ratio to determine whether a company can meet its short-term debt obligations.

Why Is Working Capital Important?

The importance of working capital is as follows:

• Working capital allows a company to keep paying its employees and suppliers while meeting other obligations, like interest and taxes.

• Working capital contributes to the goodwill reputation of the company. When external parties discover that a company's working capital is insufficient, they are unlikely to cooperate.

• Positive working capital can help a company qualify for a loan or other form of financing if it needs to borrow money.

• The goal for finance teams is twofold: know how much cash is available at any given time, and work with the business to keep enough working capital to cover liabilities and allow growth.

How To Calculate Working Capital?

A company's working capital is determined by subtracting its current liabilities from its current assets to measure its available funds for growth and operations. The working capital formula is

Working Capital = Current Assets - Current Liabilities

Positive numbers indicate that you have enough cash to cover short-term expenses and debts, while negative numbers suggest you are running out of money.

Accordingly, if a company's balance sheet shows 400,000 current assets and 300,000 current liabilities, the company’s working capital would be 100,000 (assets - liabilities).

Positive vs. Negative Working Capital

Having enough cash, outstanding accounts, and other liquid assets to cover short-term obligations, such as short-term debt and accounts payable, is a sign of positive working capital.

Negative working capital refers to a company's inability to cover its short-term financial obligations with its current assets. If your company has negative working capital, you may be unable to pay your suppliers and creditors and you may have difficulty raising funds for business growth. This situation may eventually lead to the company's closure.

Factors Affecting Working Capital

1. Current Assets

A company can convert its current assets into cash within one year or one business cycle, whichever comes first. They exclude long-term or illiquid investments, such as hedge funds, real estate, and collectables.

Examples of current assets include highly liquid marketable securities such as stocks, mutual funds, bonds, and exchange-traded funds (ETFs); checking and savings accounts; money market accounts; cash and cash equivalents, inventory, accounts receivable, and other shorter-term prepaid expenses.

2. Current Liabilities

A company's current liabilities are all debts and expenses to pay within one year or one business cycle. Current liabilities include capital leases due within one year, dividends payable, and long-term debt that is now due.

Examples of liabilities include utilities, rent, materials, and supplies; accrued liabilities; accounts payable; interest payments on debt; and income taxes accrued.

Elements Included In Working Capital

Current Assets

A company's current assets are cash and liquid assets likely to be converted into cash within the next 12 months, or when the balance sheet is prepared. To keep the business running daily, current assets provide the business with liquidity.

Examples of Current Assets:

• Cash-at-bank

• Prepaid expenses

• Accounts receivable (e.g. outstanding receipts)

• Equivalents of cash (cash-convertible investments like government bonds)

• Stock (including work-in-process, raw materials, and finished goods)

• Short-term investments

Current Liabilities

A company's current liabilities refer to all debts it must pay back within the next 12 months or by the end of the following Balance Sheet.

Examples of Current Liabilities:

• Accounts payable (e.g. supplier payments)

• Bank overdrafts

• Sales, payroll, and income taxes

• Wages

• Rent

• Short-term loans

• Outstanding expenses

Working Capital Example

Consider the following assets and liabilities for your company:

According to the above information, working capital = 3.53 lakh — 5.5 lakh = — 1.97 lakh

Negative net working capital can cause problems in running your business and prevent you from taking advantage of lucrative opportunities. Keep your business running smoothly by financing the deficit and developing a sound working capital management policy.

Ways To Increase Working Capital

Businesses may need to increase their working capital if they have to cover project-related expenses or experience a temporary drop in sales. The best way to close that gap is to add current assets or reduce current liabilities. The following methods can help add assets:

1. By getting long-term debt, you only have to pay a percentage of the loan as interest. This means you can increase the company's current assets without increasing its liabilities.

2. Taking on longer-term debt to refinance short-term debt. Because the debts are no longer due within a year, they reduce current liabilities.

3. Increasing current assets by selling illiquid assets for cash.

4. Identifying and cutting off unnecessary expenses and reducing current liabilities.

5. Reduce overstocking by analyzing and optimizing inventory management.

6. Automating monitoring of receivables and payments. It can improve cash flow, reducing the need to use working capital daily.

List of all Working Capital Formulas & Their Importance:

The following are the alternative formulae used for working capital calculation-

1. Working Capital = Current Assets – Cash – Current Liabilities (excluding cash)

In this formula, cash isn't part of current assets. Instead, you subtract it from current liabilities separately.

2. Working Capital = Accounts Receivable + Inventory – Accounts Payable

Here, accounts receivable is what others owe you, and accounts payable is what you owe. Inventory is the value of goods that can be sold and turned into cash.

3. Net Working Capital = Current Assets (excluding cash) – Current Liabilities (excluding debt)

This formula calculates net working capital by subtracting current liabilities (excluding debt) from current assets (excluding cash). It gives a clearer view of working capital, ignoring cash and long-term debt.

4. Operating Working Capital = Current Assets – Non-operating Current Assets

Non-operating current assets are separate from your core activities, like spare machinery or unused land.

5. Change in Working Capital = Working Capital (Previous Year) – Working Capital (Current Year)

This formula shows the change in working capital from the previous year. It's a good indicator of whether a company's financial health is improving or worsening.

Apply For A Business Loan

If your cash flow is low or you need more of a boost, a business loan could be just what you need. Even though it might seem intimidating, a loan can be a great way for small businesses to improve and make smart strategic decisions. IIFL Finance offers business loans with low EMIs, quick disbursements, and flexible repayment schedules to help your business grow.

Frequently Asked Questions:

Q1. How can you increase the working capital of a business?

Ans. Boosting sales, cutting expenses, or getting a loan can all help you increase your working capital.

Q2. What does negative and positive working capital mean?

Ans. Positive working capital means you have enough liquid assets to pay off your immediate debts. A negative working capital shows that your current assets cannot cover your primary debts.