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How to Calculate Working Capital: Formula, Examples, Tips

Although many business owners understand what working capital is, fewer have actually calculated how much they have. Using the net working capital formula is an important part of your business finances if you’re trying to raise money, obtain a business loan, or partner up with another company for a project. Working capital is a balance sheet calculation, meaning that every number you need to calculate net working capital should appear on your most recent balance sheet. If you don’t know how to create a balance sheet, use our free balance sheet template.

Keep reading to find out how the working capital formula works, see an example of the working capital formula, and figure out how to interpret the results for your business. 

Working Capital Formula

The working capital formula—your business’s current assets minus your business’s current liabilities—is an accounting formula that can help you calculate just how much your business is working with. A positive number shows that your company has enough cash and other liquid assets to cover short-term debts and expenses.

Here’s the basic formula for working capital:

Current Assets – Current Liabilities = Net Working Capital

Positive net working capital means the following:

  • Your business has good short-term liquidity.
  • Your business has enough cash and liquid assets to pay off short-term liabilities.
  • Your business is cash-flow positive in the short term, which means you can grow faster.

Negative net working capital means the opposite:

  • Your business has low short-term liquidity.
  • You don’t have enough assets to pay off all of your business’s short-term debts.
  • Your business is cash-flow negative in the short-term, which means you can’t grow as quickly.

Current Assets

The working capital formula is pretty straightforward, but one common question is what to count as “current assets” and “current liabilities.” Business owners, accountants, and lenders sometimes have different preferences.

Current assets are cash and anything that you can easily convert to cash during the time period at issue. For example, you can relatively easily sell or liquidate inventory for cash, so that’s considered a current asset. Current assets usually include the following:

  • Cash in business bank accounts, such as checking and savings accounts and CDs
  • Accounts receivable that are outstanding and owed to the business
  • Stocked inventory
  • Short-term investments, like stocks and bonds that the business holds in another company
  • Interest payable (if the business has loaned money to another business)

Current Liabilities 

Current liabilities are any loans or expenses that you owe during the time period at issue. Current liabilities generally include the following:

  • Short-term loan payments that are due within the calculation period
  • The portion of long-term loans that you have to pay during the calculation period—use a loan amortization schedule to figure out this amount
  • Accounts payable
  • Accrued expenses for the calculation period, such as loan interest, taxes, and wages

Outlining your company’s assets and liabilities and calculating your working capital allows you to spot business risks. For instance, if your company has a lot of money tied up in real estate, equipment, and other fixed assets, you’ll have difficulty paying your bills when they are due. Ideally, a small business should strive for a balance of fixed assets and liquid assets.

Working Capital Formula Example

Here’s an example of how to calculate net working capital, using a sample business called ABC Manufacturing. We start out with the company’s assets and liabilities for the coming year:

ABC Manufacturing Current Assets:

  • Cash in the bank: $100,000
  • Outstanding accounts receivable: $400,000
  • Inventory: $500,000

Total current assets = $1 million

ABC Manufacturing Current Liabilities:

  • Outstanding accounts payable: $300,000
  • Short-term debt payments due this year: $30,000
  • Portion of long-term debt due this year: $25,000
  • Other accrued expenses for this year (e.g., rent, payroll, etc.): $400,000

Total current liabilities = $755,000

In this net working capital formula example, to find ABC Manufacturing’s working capital, we would subtract the total of their current assets from their total current liabilities by doing the following:

ABC Manufacturing Net Working Capital = Current Assets – Current Liabilities

$1 million – $755,000 = $245,000

ABC Manufacturing has $245,000 in working capital. The company will have an estimated $245,000 left over at year’s end after paying all of their expenses and obligations. That means ABC is in a strong financial position for the coming year.

We calculated working capital for a one-year period for this example, but you can also go with a quarterly or monthly calculation. In that case, you’d include accounts receivable that will be paid within the quarter or month, and you’d include debt payments that are due within the quarter or month.

Net Working Capital Formula vs. Working Capital Ratio

Working capital ratio is a formula that’s closely related to net working capital. Similar to the net working capital formula, the net working capital ratio formula compares your business’s assets and liabilities. Instead of subtracting these numbers, you divide them to get a ratio. The working capital ratio formula is as follows:

Current Assets / Current Liabilities = Net Working Capital Ratio

In our example above, you’d divide $1 million by $755,000 to get 1.3. That means the company has 1.3 times as many assets as liabilities. Ideally, you should strive for a working capital ratio between 1.2 and 2.0.

Gross Working Capital vs. Non-Cash Working Capital

We’d be remiss if we didn’t talk about gross working capital and non-cash working capital in this working capital formula breakdown. Gross working capital is a measure of all your company’s financial resources, focusing specifically on total current assets. This means it does not subtract liabilities. Net working capital, on the other hand, offers you a clearer picture of your company’s finances because it does factor in liabilities.

Non-cash working capital actually can be beneficial when determining your company’s financial outlook. That’s because it only considers the value of your company’s inventory and accounts receivable. To calculate non-cash working capital, you simply subtract cash and all cash equivalents from your current assets. The formula looks like this:

(Inventory + Accounts Receivable) – Current Business Liabilities = Non-Cash Working Capital

Because industry standards determine what a business’s non-cash working capital should be, it can serve as a good barometer for how you match up with competitors.

5 Ways to Improve Your Net Working Capital

Scott Orn, chief operating officer at Kruze Consulting, says changes in the working capital are more important than a single calculation:

“Changes in working capital as a company grows are usually more important than the absolute number, since the change tells you about how the company’s cash will be used as the business grows.”

In other words, working capital is a number you should monitor regularly and hopefully see an upward trend in as your business grows. A change in working capital formula is to be expected, but it’s up to you to understand what those changes mean for your business.

Here are some actionable ways to improve your net working capital:

1. Improve Your Business’s Profits

The simplest way to improve working capital, but one that people often overlook, is to increase profits. You can accomplish this by upping your revenue or cutting costs. Cutting back on staffing or adapting your marketing spend could have the intended result.

To increase revenue, you can find working capital for startup businesses. Paola Garcia, a small business advisor at Excelsior Growth Fund, says,

“Working capital will only increase if you put more money into the business yourself or if you retain profits in the business. That’s where it may make sense to work with a lender to support your working capital strategy.”

We know what you’re thinking: Won’t taking on debt lower my working capital? In the short term, the interest you have to pay off the loan will decrease your working capital. However, if you can channel that debt to improve your business’s bottom line, as we’ll go over in the next tip, then you’ll end up with more revenue and profits in the future.

2. Finance Fixed Assets With a Long-Term Loan

Instead of financing fixed assets like equipment with working capital, consider taking out a long-term loan. When businesses use up all of their available cash, they appear more risky to investors and lenders. On the other hand, a loan allows you to keep a healthy cash flow and pay off your suppliers quickly, which may help you build stronger relationships and secure discounts. This can help make up for the interest paid on the loan.

3. Collect Accounts Receivable More Quickly

Reducing your accounts receivable (AR) cycle turns money tied up in invoices into cash. This strengthens your working capital position. You can bill new customers with a Net 15 or Net 30 invoice, instead of longer Net 60 or Net 90 terms. You can also encourage customers to pay you early with prompt payment discounts.

4. Avoid Stockpiling Inventory

Another way to improve your business’s net working capital calculation is by carefully managing inventory levels. Although inventory is considered an asset in the working capital formula, lenders and suppliers prefer to see businesses that have more cash and less inventory that’s gathering dust on the shelves.

Make sure you order only the amount of inventory that you’ll be able to move off your shelves within a reasonable amount of time. Inventory management software can help you monitor inventory levels and set up automatic orders when inventory dips below a certain level.

5. Liquidate Unused Long-Term Assets

Similar to unused inventory, unused long-term assets hurt your business’s short-term cash position. If you have, for example, equipment or a portion of your office space that you’re not using, sell or rent out those assets and convert them to cash.

Of course, you need to balance all of these strategies against other priorities for your business. You don’t want to sell off all your equipment, for instance, if it could potentially serve as a type of collateral to help you secure a much-needed business loan.

6. Lower Your Debt Payments

Lowering your debt payments increases your working capital. If you have an existing loan with a history of on-time payments, you might be able to refinance your business loan, also known as debt refinancing. Particularly if your credit score or business revenue have improved since initially getting your loan, you’re a good candidate for refinancing.

The Bottom Line

The working capital formula is an important measure of your business’s short-term liquidity. When calculating your net working capital, keep the following in mind:

  • You can calculate working capital by subtracting current liabilities from current assets.
  • A positive working capital is better than a negative working capital for most businesses, except for businesses with high inventory turnover.
  • Lenders can assess working capital by looking at your bank statements or balance sheet.
  • You can improve your working capital by increasing profits, cutting debt and other costs, collecting accounts receivable faster, liquidating long-term assets, and smartly managing inventory levels.

Remember that working capital is a dynamic number. Sometimes, things outside of your control might cause your working capital to decline. But there are also actionable steps you can take to improve this number and grow your small business.

The post How to Calculate Working Capital: Formula, Examples, Tips appeared first on Fundera Ledger.

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