Working capital is used to measure the cash and liquid assets available to finance the day-to-day operations of a business. Having this information can help you run your business and make good investment decisions. By calculating working capital, you can determine if and for how long a business will be able to meet its current obligations. A company that has little (or no) working capital generally does not have a good future. This calculation is also useful for assessing whether a company is making efficient use of its resources. The formula for calculating working capital is:
Working capital = current assets - current liabilities.
Steps
Part 1 of 2: Doing Basic Calculations
Step 1. Calculate current assets
Current assets are the assets that a company will convert into cash within a year. These assets include cash and other short-term accounts. For example, active invoices, prepaid expenses, and inventory are current assets.
- Typically this information can be found in a company's financial statements, which should include a subtotal of current assets.
- If your financial statements don't include a subtotal of current assets, read the document line by line. Add up all accounts that fall under the definition of "current assets" to calculate a subtotal. For example, you should include the figures indicated as "active invoices", "inventory" and "cash and cash equivalents".
Step 2. Calculate current liabilities
Current liabilities are the debts that the company would have to pay in one year. They include payable invoices, accrued liabilities and short-term bills of exchange.
The financial statements should include a subtotal of current liabilities. If not, use the information on this document to calculate the total by adding the liabilities shown. For example, you should use figures labeled "provisions", "taxes" and "short-term loans"
Step 3. Calculate working capital
This calculation must be performed with a simple subtraction. Subtract the total of current liabilities from that of current assets.
- For example, imagine a firm has current assets of $ 50,000 and current liabilities of $ 24,000. The company is expected to have a working capital of 26,000 euros. It should be able to pay all current liabilities from current assets and still have funds that will be used for other purposes. He could use this money to finance operations or for long-term debt payments. It could also distribute it among shareholders.
- If current liabilities are greater than current assets, the result would be a deficit working capital. This deficit could indicate that the firm is in danger of becoming insolvent. Consequently, this could mean that it is in crisis and that it is hardly a good investment.
- For example, consider a company that has $ 100,000 in current assets and $ 120,000 in current liabilities. It has a working capital in deficit which amounts to 20,000 euros. In other words, the company is unable to meet its current obligations and has to sell long-term assets worth € 20,000 or find other sources of funding.
Part 2 of 2: Understanding and Managing Working Capital
Step 1. Calculate the liquidity ratio
For a closer look, many analysts use an indicator of a firm's financial strength called a "liquidity ratio". The calculation is based on the same numbers indicated in the first two passages of the first part of the article, but, instead of a figure in euros, it provides a quotient.
- A quotient is a tool for comparing two dependent values. Calculating a mathematical ratio usually consists of a simple division.
- To calculate the liquidity ratio, divide current assets by current liabilities. Liquidity ratio = current assets ÷ current liabilities.
- Using the example of the first part, the firm's liquidity ratio is: 50,000 ÷ 24,000 = 2.08. This means that the company's current assets are 2.08 larger than current liabilities.
Step 2. Understand the usefulness of the liquidity quotient
It is a tool for assessing a firm's ability to meet its current financial obligations. Basically, it tells you if a company is able to pay the bills. When comparing different companies or industries, it is often best to use the liquidity ratio.
- The ideal liquidity ratio is around 2.0. A falling ratio or less than 2.0 could indicate a higher risk of default. On the other hand, a quotient above 2.0 could mean that management is too conservative and reluctant to take advantage of the firm's opportunities.
- Using the example above, a liquidity ratio of 2.00 is usually positive. You could interpret this by concluding that current assets can finance current liabilities for about 2 years, obviously assuming that the liabilities remain at the same level.
- A liquidity ratio that can be defined as acceptable varies from one sector to another. Some industries are capital intensive and may need loans to finance operations. Manufacturing firms, for example, are prone to high liquidity ratios.
Step 3. Manage working capital
Business managers need to keep track of every aspect of working capital to keep it at an optimal level. This includes taking care of inventory, and invoices and receivables. They must evaluate the profitability and the risks that arise from underuse or excessive use of working capital.
- For example, a firm with little working capital risks being unable to pay current liabilities. However, having too much working capital can still be a problem. A company that has excess may be able to invest in long-term productivity improvements. For example, surplus working capital could be invested in new manufacturing infrastructure or retail stores. These types of investments can increase future income.
- If working capital is too high or low, read the Tips section for ideas on how to improve it.
Advice
- Avoid being paid late by customers by learning how to manage debtors. If it is urgent to receive income, you may want to offer discounts on prepayments.
- Pay off short-term loans before they mature.
- Don't buy fixed assets (such as a new plant or a new building) using short-term loans. It is difficult to convert assets into cash to pay off short-term loans. This will have a negative impact on working capital.
- Manage inventory. Try to avoid over or under supply. Many manufacturing industries use the Just-In-Time (JIT) method for inventory because it is cost effective. In addition, less space is used to store goods and damaged inventory decreases.
