Working capital is a financial metric that allows businesses to understand their operational liquidity, or in simple terms, how much cash is actually available to use within the business.
As businesses can become tied up in many debts and financial obligations, it can often be difficult to determine how much money a business has available. Working capital is therefore a measurement of this available cash.
How do I calculate working capital?
To calculate working capital, simply use the formula below:
Current assets – Current liabilities = Working capital
The amount left over will be your working capital – this is the cash free of any obligations. This is known as positive working capital.
On the other hand, if the outcome is negative, this means that you have negative working capital, which is a problem. This means you owe more than you have available, and could indicate some financial challenges for your business.
Current assets
To find your current assets, you will need to look at your business and what it owns.
Here are the four components of working capital.
- Cash & cash equivalents (quickly convertible assets, such as bonds)
- Accounts receivable (money owed to your business)
- Inventory (property, goods)
- Marketable securities (stocks and shares)
These are all profits that your business has and can be guaranteed profits if used or sold.
Current liabilities
In simple terms, liabilities are what your business owes. This is important to understand for working capital, as you will be able to see how much cash you are actually free to use.
Liabilities will include things such as:
- Accounts payable (outstanding payments)
- Short-term loans
- Taxes owed
- Accrued wages
- Rent
These are all payment obligations that will eat into your current assets, so it’s important that you keep track of all your liabilities. A working capital calculation will allow you to understand how impactful your liabilities are on your business.
Are working capital and profit the same thing?
No, working capital and profit are not the same thing.
Profit is the surplus money that is arriving into the business, once all expenses have been deducted. However, profit does not take into account current liabilities. Business owners can often get caught out by thinking that profit is a clear indication of the success of a business, forgetting their liabilities, which could actually surpass their profits.
Why is working capital important?
Working capital is absolutely crucial. Quite simply, businesses with negative working capital will not be able to survive – if they continue on the same track, they will run out of money.
If working capital is positive, it means that a business is making money, and able to cover its liabilities and any liabilities that may crop up in future.
Working capital is also important for:
- Financial planning
- Investment decisions
- Measuring operational efficiency
Running a successful business is about maintaining cash flow, and ensuring that profits can be consistently made. Working capital is important because it will show how financially flexible you are, and whether you need to make additional investments or perhaps pay off some larger liabilities to free up capital.
3 examples of working capital
There are different types of working capital, each intended to give an indication of the health of a business.
Here are all the main types that you will come across.
Working capital
Working capital is the most basic form, and will give a clear indication of whether you have free capital to spare.
As stated earlier, the calculation for working capital is:
Current assets – Current liabilities = Working capital
Net working capital
Net working capital is similar to working capital but removes cash from the equation. This is to provide a greater focus on the core operations of the business.
Cash is also often seen as working capital that has already been and gone, or already “worked”. It is no longer providing income in itself, so is not necessarily an indication of future returns.
The calculation for net working capital is:
Current assets (excluding cash) – Current liabilities (excluding debts) = Net working capital
Operating working capital
Operating working capital is a slightly different measurement of working capital that measures the capital used specifically for day-to-day operations.
Operating working capital measures the ‘operating’ assets and liabilities of a business, which are assets and liabilities that will affect business operations. Things such as investments and cash equivalents may be excluded.
The calculation for operating working capital is:
Current operating assets – Current operating liabilities = Operating working capital
Change in working capital
It can be useful to measure change in working capital, to provide an indication of where the business might be heading year-over-year (YoY). If working capital has increased since the previous year, this could be a sign of business growth, and if a negative change is seen, this might be a sign to adapt the business and avoid potential negative working capital in the following years.
The calculation for change in working capital is:
Working capital (current year) – working capital (previous year) = Change in working capital
How can a company improve working capital?
Improving working capital can be done by first calculating working capital, and then assessing what could be changed or removed.
Often heavy liabilities will be the cause of negative working capital, so once you have made an assessment, you can take a look at your largest liabilities and see if they can be reduced or paid off.
Other issues for excessive liabilities can be in things such as:
- Excess stock
- Slow-moving items
- Unpaid invoices
Negotiating favourable payment terms with suppliers can also be very effective, as this can free up your cash flow, which can then in turn allow you to tackle some of your liabilities.
You might also want to use a short-term business loan such as invoice financing to cover some of your costs and ensure that you don’t have negative working capital.
Conclusion
Working capital is a crucial part of business management and measuring your financial success. Businesses’ financials can become complicated, so using working capital is a surefire way to assess how your business is performing.
We have many loans available at Rise Funding that you can use to improve your working capital.
If you are looking for a loan, but aren’t sure what to go for, then Rise Funding you can get an instant business quote in seconds.
You can also use the form below to help you find the business funding that you need.
