Working capital: What it is, how to calculate and more
Learn about working capital and how to calculate it to assess your business. Presented by Chase for Business.
Working capital is the backbone of your business’s financial health. It’s what keeps you afloat during times of trouble, and understanding it allows you to know how much money you have available to cover immediate business expenses versus money tied up in investments. Let’s take a closer look at what it is, how it works and how you can calculate yours.
What is working capital?
Working capital is a comparison between a company’s current assets and its current liabilities over the next year. Basically, it answers: How much do you have that can be converted to cash versus how much do you owe? This is helpful to know because there might be times when a business needs to sell assets or spend down cash reserves. Working capital numbers can help you evaluate how resilient your business would be in a downturn. On the positive side, calculating working capital can also show you when it’s a good time to spend money on your business.
Why is working capital important?
When your business has enough working capital, you can meet all your short-term financial obligations, such as paying employees and suppliers. This means you’re funding your business without taking on any debt, which may make it easier to qualify for loans in the future. If your business doesn’t have enough working capital, then it can hinder your ability to pay bills on time, manage inventory and take advantage of investment opportunities.
How to calculate working capital
Wondering how to find your working capital number? First, gather up your business’s current assets and liabilities. Then, you can plug them into one of the easy-to-use equations for working capital calculation:
Working capital formulas
- Working capital formula: To use the formula for calculating working capital, which is the amount of assets after liabilities, simply subtract your business’s current liabilities from its current assets.
Current Assets − Current Liabilities = Working Capital
- Working capital ratio formula: To calculate your working capital ratio, which is the strength of your ability to quickly get cash by selling materials or inventory compared with looming expenses, you can divide your business’s current assets by its current liabilities.
Current Assets ÷ Current Liabilities = Working Capital Ratio
Components of working capital
Current assets and current liabilities are included in working capital if they are accessible or due within 12 months. Assets must be current, meaning they can be accessed within 12 months. Liabilities must be current, meaning the company has to pay them within the next 12 months.
Business assets can include:
- Cash
- Investments you can convert to cash
- Money owed to you
- Materials and inventory
- Prepaid expenses
Liabilities can include:
- Payments owed
- Taxes
- Employee wages
- Rent
- Loan payments
- Other outstanding expenses
What is a good working capital ratio?
A low working capital ratio can indicate a problem, but how low is too low?
Each business will have its own sweet spot based on the particulars of its assets and liabilities. Generally speaking, a working capital ratio near or below 1.0 could indicate a greater risk. Why? Remember that assets include nearly everything of value in your business, not just cash. If a dwindling supply of cash forces you to sell off assets that you need for future sales, you’ve gained cash, but you may have lost revenue potential. The deeper a business has to dig into its assets, the greater the risk that it won’t have enough assets to continue to generate revenue.
At the other end of the scale, a 2.0 working capital ratio means the company has double the capital to cover its expenses for the next year, which is very good but could signal a different kind of problem.
A business that’s hoarding cash is missing opportunities to put cash toward expenses that can increase revenue. Plus, the business could be paying higher taxes on all that stagnant money. Other businesses might have a high working capital ratio because they’ve invested heavily in inventory. On the one hand, inventory is good because it means you have something to sell, but too much inventory could put pressure on your cash flow. A business that’s low on cash may need to sell off inventory more quickly, which could mean offering steep discounts just to get cash in the door.
You may also read our article Working Capital vs Cash Flow to learn more about the differences.
Working capital example
How does it work in real life? Let’s take a look at a couple examples of working capital and working capital ratio:
Let’s say Business A has $2 million in assets and $1.95 million in liabilities, which comes to a net working capital of $50,000. Business B, with $200,000 in assets and $150,000 in liabilities, also has a net working capital of $50,000. But even though their net working capital is the same, one business is in a much riskier position than the other.
Business A has a working capital ratio of 1.03 (2 million divided by 1.95 million), which means that if no revenue comes in over the next year, its assets will barely cover its liabilities. However, Business B has a working capital ratio of 1.5 ($200,000 divided by $150,000), which means it is much more likely to weather a sudden drop in revenue.
Why is working capital essential for business success?
Without enough working capital, a business can face a number of hardships including bankruptcy if it doesn’t have the cash necessary to cover all its liabilities. That’s why it’s a good idea to have a good understanding of working capital and regularly calculate your working capital ratio, so you can make sure you have enough cash to cover your expenses.
Other working capital calculations and formulas
- Net working capital formula: Some analysts believe the net working capital formula can be used to give a more holistic perspective of a business’s health by excluding cash and debt.
(Current Assets − Cash) − (Current Liabilities − Debt) = Net Working Capital
- Operating working capital formula: To better understand the liquidity of a business, you can remove cash securities and short-term non-interest debts from the formula.
Current Assets − Non-operating Current Assets = Operating Working Capital
Ready to grow your working capital?
We have an article with a few tips. If you’re unsure what working capital means for your business, it might be helpful to speak with a Chase business banker to discuss which products can help get the most out of your working capital. Remember to review your working capital often to help understand your company’s finances.
Working capital FAQs
How to improve working capital?
To improve your business’s working capital, you can take various actions, including but not limited to increasing the amount of cash assets or investments that can be quickly sold for cash to create more working capital.
What does a negative working capital mean?
A negative working capital means your business’s debt exceeds the amount of assets you have available to pay it off. If this happens, you’ll want to work on increasing working capital right away.
What is included in working capital?
What’s included in your working capital are assets that can be accessed within 12 months and current liabilities that your business has to pay within 12 months.
