How to Calculate Working Capital and Build Your Reserve
15 September 2022 |
The C2FO Team
A healthy supply of working capital is essential to your business. Find out what working capital is, how to calculate it, how to effectively manage it and how you can increase it.
Working capital is the money a business uses to pay for everyday operational expenses such as utilities, supplies, payroll, inventory and rent. It can also be a key indicator of your business's health — specifically, liquidity, operational efficiency and budget management.
To stay in business and succeed, you need to be able to keep up with your day-to-day costs, expenses and debts. Moreover, when you are looking to expand or scale your business, having an adequate amount of working capital on hand is vital. All of these costs — operational or growth-related — rely on a healthy cash balance. Therefore, effective working capital management is crucial to the success of your business.
With that being said, there are a few questions to answer: What does having working capital mean for your business? How is it calculated? In this post, we’ll cover everything you need to know about working capital so your business can remain resilient in uncertain times and seize growth opportunities when they arise.
What is working capital?
Working capital is the difference between a business’s current assets (for example, cash, invoices and inventory) and current liabilities (for example, accounts payable). To be considered “current,” these liabilities and assets are due to be paid or accessible within one year (or one business cycle, whichever is less).
Note that working capital is different from operating cash flow, which is affected by many factors, including expenses, investments, sales and loans. Working capital isn't just a measure of a business's liquidity — it also delivers valuable insight into operational efficiency and financial health.
One way to determine whether your business has the cash flow necessary to meet your debt and operational demands is to use the “net working capital” formula. We’ll get to that in a moment. But first, let’s take a closer look at current assets and liabilities.
An asset is anything of financial value that your company owns. It can be tangible or intangible. Current assets refer to the assets your business can quickly and easily use, replace and/or transform into cash in the short term or in a typical operating cycle (usually within 12 months).
Generally, you would itemise current assets on the balance sheet from most liquid to least liquid. For instance, cash would be listed above inventory because cash is more liquid. Examples of current assets include:
Stocks, bonds, mutual funds and exchange-traded funds (ETFs) that will be liquid within the next year
Checking and savings accounts
Money market accounts
Cash and cash equivalents
Current liabilities are obligations or debts that are payable within one year, in contrast to long-term liabilities, which are payable beyond 12 months.
Paying off current liabilities is mandatory. For this reason, you should monitor them closely to ensure your company has sufficient liquidity to pay them off when they are due. Examples of current liabilities include:
Payroll within the next year
Outstanding bills (accounts payable to vendors, suppliers, utilities, etc.)
Income taxes owed
Mortgage, lease or rent payments
Loans due within 12 months
Interest and fees on loans
Dividends payable to investors
The net working capital formula
Working capital is calculated by finding the difference between current assets and current liabilities. Understanding this equation is fundamental to managing your working capital.
For example, if your balance sheet has £250,000 in current assets and £200,000 total current liabilities, your working capital is £50,000.
An alternative measure of liquidity: the working capital ratio
Alternatively, you can measure liquidity by calculating your business’s working capital ratio. This ratio is meant to indicate how capable your company is at meeting its current financial obligations. Simply divide total current assets by total current liabilities to get a ratio, such as 2:1 (twice as much in assets) or 1:1 (equal assets and liabilities).
Using figures from the net working capital example above, the working capital ratio would be 250,000 ÷ 200,000 = a working capital ratio of 5:4. Generally, the higher the number, the greater level of comfort you can have that your company can meet its payment obligations.
Negative working capital can be a challenge
The higher your net working capital or working capital ratio, the better position you are in to manage planned or unplanned expenses and the greater your ability to expand your business. However, your working capital can be negative when your current assets are lower than your current liabilities, and this can present challenges to your business.
With positive working capital, you have enough cash, accounts receivable and other liquid assets to cover your needs in the short term, such as accounts payable and debt. Therefore, when you don’t have enough current assets to cover your short-term financial obligations, it may mean you’ll struggle to pay creditors, suppliers or invest in growth opportunities. For instance, a working capital ratio of 2:1 typically means you have a healthy cash buffer. A ratio of less than 1:1, on the other hand, could indicate that you may have trouble paying bills.
That said, it isn't always a good thing if your net working capital is higher than 2:1. It could signal your capital is sitting idle rather than being reinvested in growth or you have an overstock in inventory.
How to increase your working capital
Whether you use your working capital to sustain operations and make payroll, or for scaling your business, creating and maintaining a healthy reserve is essential for long-term success. However, this can be a major challenge for small to mid-sized businesses, especially in times of uncertainty.
Post-pandemic consumer demand, supply chain disruptions and rising inflation have all increased the pressure on companies to effectively manage their cash and preserve profit margins to maintain a healthy supply of working capital. The following tactics can help you to optimise your net working capital and build a sufficient cash reserve to expand your business or overcome times of economic uncertainty:
Shorten operating cycles
Optimise receivables processes
Incentivise early payment with dynamic discounting
Improve inventory management
Identify unnecessary expenses and cut costs where possible
Reduce bad debts or refinance for better rates
Obtain additional funding
Working capital supports your daily running costs, funds larger projects and can help your business stay afloat during even the most trying times. Calculating your working capital is a quick way to gain an overview of your company’s financial health and operational efficiency.
A strategic approach to working capital management should include initiatives within inventory, accounts receivable and accounts payable operations. By optimising operational processes and carefully monitoring your business’s finances, you can build and maintain a strong working capital reserve and see significant improvements to your bottom line.