Working capital is an accounting term, which refers to the firm’s available capital for daily operations. It is the amount of cash that is in your possession enabling you to operate while meeting your obligations at the same time. It is very important to calculate working capital for your business as that will give you a clear picture of where your company stands and where you are heading towards.
An account professional if asked to define working capital would define it as the difference between current assets and current liabilities. In order for a business to function efficiently, the company must have more assets and less of liabilities. This is to ensure that the firm has good enough assets to pay its debt. The amount of working capital that a business has depicts its financial health.
How to Calculate Working Capital
Working Capital = Current Assets – Current Liabilities
The working capital must always be a positive number. If negative, the chances are high that you will run out of cash and will not have enough money to keep your business going.
The way to calculate working capital is by using the current ratio, which is current assets divided by current liabilities. Current assets exceed liabilities if a ratio is above 1 and the higher the ratio, the better.
Current Ratio = Current Assets/Current Liabilities
To give you an example:
Imagine that a company has cash of $500,000 in hand. A sum of $250,000 is outstanding and owed to the company in the form of accounts receivable. It has inventory and physical property assets of $1 million. Its current assets are hence $1.75 million.
When it comes to the company’s liabilities, it owes $50,000 in short-term debt, $100,000 in accrued liabilities, and $400,000 in accounts payable. The firms’ current liabilities are hence $550,000.
Upon subtracting the company’s current liabilities from its current assets, we can get a working capital of $1.2 million.
This company, we know, has the capacity to expand internally since it has the available funds.
The Importance of Working Capital
A company must ideally have enough working capital (to pay all its bills) to last for a year. It is possible to predict if a company has enough resources or will need to borrow from a bank or financial institutions by merely studying working capital levels.
One of the main advantages of assessing the working capital of a business is being able to predict potential financial problems that might come up from time to time. It is necessary to remember that even a business which has billions of dollars in assets can become bankrupt if it is unable to pay its bills on time.
Insufficient working capital can lead to immense financial strain on a company, thereby increasing the chances of applying for a loan, late payments to creditors and vendors. This, in the long run, can lead to a lower credit rating for the company. This is bad news because banks will charge high-interest rates from companies that have a low credit rating. All this will eventually cost a lot of money to the company.
Whether your company is a startup or has been running smoothly and experiencing growth, it is imperative to have a good grasp of your company’s working capital and hence you must know exactly how to calculate working capital.
The amount of working capital and the working capital ratio will be different for each company. That is because of many factors, which include asset purchase timing, and differences in collection and payment policies among many others. It is nevertheless a useful tool to determine your business’ profitability and can be used to make informed and smart decisions for your business anytime.