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Simply put, working capital is the money available to a company to handle all of its operating activities for the upcoming year.
But before we explain working capital in more detail, it’s important to understand current assets and current liabilities, since these two accounting terms are the main components used in calculating working capital.
If you wish to get a long-term view of financial health, you can also calculate operating working capital, since operating working capital focuses on long-term assets and liabilities.
Working capital is money that is currently available to your business to use for day-to-day operations. Working capital is also a good indicator of overall financial health since it involves all of the following activities:
The only difference between working capital and net working capital is how they're reported, as net working capital usually refers to a total, while working capital is reported as a ratio.
The net working capital formula is as follows:
Current Assets - Current Liabilities = Net Working Capital
Using this formula will help you arrive at your working capital total. For instance, if your current assets total $125,000 and your current liabilities total $95,000, your calculation would be:
$125,000 - $95,000 = $30,000 Net Working Capital
Toi calculates working capital as an accounting ratio, you can use the following formula:
Current Assets ÷ Current Liabilities = Working Capital Ratio
Using the same numbers as above, your calculation would be as follows:
$125,000 ÷ $95,000 = 1.32 Working Capital Ratio
This means that for every $1 in current liabilities you have, you have $1.32 in current assets available to pay them off.
The working capital ratio formula is similar to the quick ratio, but includes inventory, which the quick ratio excludes. The working capital ratio measures a company’s overall liquidity, including its ability to pay off any short term liabilities with short term assets.
Though working capital is an easy calculation, the number can tell you a lot about the health of your business. For instance, a working capital ratio of less than one indicates that your business is facing severe liquidity issues and does not have enough current assets to pay current liabilities.
It can also tell potential investors and financial institutions that your company is stable and operating well within its means to pay any upcoming liabilities. Here are a few other things that working capital can tell you about your business:
As a business owner, you’re responsible for everything from paying the rent on time to making sure your employee’s paychecks don’t bounce.
Your working capital provides you with the information you need in order to know whether you’ll be able to fulfill all of your financial obligations for the upcoming year or need to make changes.
While the numbers on your cash flow statement and profit and loss statement provide you with an indication of how your business is performing, neither report can provide you with a good indicator of how financially stable your business will be for the next year.
The working capital ratio provides you with a good look at the total liquidity of your business for the upcoming year.
The working capital metric is particularly important to potential investors and financial institutions that you may be looking to do business with. The deceptively simple working capital number or ratio can provide a lot of information about your business, particularly how it will fare throughout the current fiscal year.
Sometimes referred to as negative working capital, a working capital ratio of less than 1 means that your business will be considered a risk by investors and financial institutions. It also means you run the risk of not being able to pay your bills on time.
Imagine trying to run your household without knowing how much money you had coming in and not knowing how much money you needed to pay your bills. Calculating working capital for your business provides you with those answers.
It can also pinpoint potential areas of trouble before they become a major impediment to the health of your business.
No. Whether you choose to calculate working capital as a ratio or prefer the net working capital calculation, the formula is simple:
The average working capital ratio is 1; meaning that for every $1 of current liabilities, you have a $1 in current assets. A working capital ratio of between 1.5 and 2 indicates solid financial stability, and usually indicates that assets are being used properly.
A working capital ratio of less than 1 suggests potential liquidity issues, while a working capital ratio of more than 3 suggests that assets aren’t being utilized properly.
No matter what part of the life cycle your business is in, calculating your working capital is important. While it’s possible to calculate this ratio manually, the best way to calculate your working capital is by using accounting software.
If you’re looking to automate your business or are just in the market for something new, be sure to check out The Ascent’s accounting software reviews.
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