Why you Need to Know about Working Capital and How to Calculate it

Money is critical to the success of a business because it allows the business owners to pay for products to sell, advertise, purchase needed supplies, and travel to meet the needs of their customers.

Without adequate working capital business owners cannot build inventory or purchase raw materials which they then won’t have on hand to sell, and generate profits to keep the business operating.

Working Capital, which is the difference between a business’s current assets (your cash, outstanding receivables, inventory, etc.) and its current liabilities (accounts payable etc.), measures the amount of cash that a business has on hand at any time.

Current assets, are any asset which can quickly be turned into cash, so cash, obviously is quite liquid as it’s already cash, but inventory could be sold for cash, and receivables are the people who owe the business money, and those too could be quickly turned into cash.

Current liabilities, like accounts payable, an operating line of credit from a bank, and the current portion owing of a long-term debt, represent money that the business has to pay out in a relatively short period of time so business cannot count on having those funds available when they look to see how much money they have at a given time.

Taxes, would be a current liability.

Working Capital, then, measures liquid assets that a business has, after all the current liabilities have been paid and this financial calculation tells us whether a company is in a good position or bad position to handle its debts, or if it is using its assets effectively.

Working Capital = Current Assets – Current Liabilities

Having a small amount of Working Capital isn’t necessarily a bad thing, as it could just mean that the business is able to operate without borrowing on the profits it makes from its products and services.

Companies with a larger amount of Working Capital, however, could be using that cash in a better way, as it’s likely that they are not using their assets to increase revenue in the most efficient way and instead of investing it into the growth of the business are just holding the assets.

Excessive Working Capital can be reduced, for example, by selling inventory if there is a lot of it.

When trying to figure out of you have a good amount of Working Capital in your business, tax professionals calculate their Working Capital Ratio, which is calculated by taking the total of all Current Assets and dividing that amount by the total of all Current Liabilities.  That amount (also called the Current Ratio) is considered good if it’s close to 2:1.

A Working Capital ratio within the range of 1.2 to 2.0 means they is enough liquid cash available to pay bills.

What is your Working Capital Ratio?