Working capital is a simple formula that offers deep insight into the short-term financial health of your business. By calculating your business working capital, you can better understand your company’s liquidity, operational efficiency and resilience. You can also gain insight into how and when to grow.
Ready to calculate your working capital? Get out your calculators and let’s go.
Running the numbers
Working capital is a comparison between a company’s current assets and its current liabilities over the next year. Basically, it asks: 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 your working capital can show you when it’s a good time to spend money on your business.
To calculate working capital, first add up 12 months of your business assets. These can include:
- Investments you can convert to cash
- Accounts receivable (money owed to you)
- Materials and inventory
- Prepaid expenses
Next, add together 12 months of business liabilities, such as:
- Accounts payable (payments owed)
- Loan payments (only what’s owed over the next 12 months)
- Other outstanding expenses
To calculate the amount of assets after liabilities in dollars (net working capital), simply subtract liabilities from assets.
Net working capital
Assets-Liabilities=Net working capital
To see the strength of your ability to quickly get cash by selling materials or inventory compared with looming expenses (working capital ratio), divide your assets by liabilities.
Working capital ratio
Assets/Liabilities=Working capital ratio
Seeing it in action
Your working capital ratio helps you see the bigger picture of how your business is doing. For example, 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 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.
Determining which equation is most useful
Both working capital formulas are useful. Which one you use depends on what you need to know.
Net working capital lets you know the dollars you have available to work with. If you’re watching your cash flow closely and want to make sure you have the capital to keep operating in six months, net working capital can help you see how low your cash balance might get. On the other hand, if your business is profitable and you’re accumulating cash, knowing your net working capital can help you decide if it’s time to make a big equipment purchase that can help your business grow.
Finding your sweet spot
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.
Want 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 business banker to discuss which products can help get the most out of your working capital.
For informational/educational purposes only: The opinions expressed in this article may differ from those of other employees and departments of JPMorgan Chase & Co. Opinions and strategies described may not be appropriate for everyone and are not intended as specific advice/recommendation for any individual. Information has been obtained from sources believed to be reliable, but JPMorgan Chase & Co. or its affiliates and/or subsidiaries do not warrant its completeness or accuracy. You should carefully consider your needs and objectives before making any decisions and consult the appropriate professional(s). Outlooks and past performance are not guarantees of future results.
JPMorgan Chase Bank, N.A. Member FDIC. ©2023 JPMorgan Chase & Co.