Working capital represents a business or individual’s financial assets, their property, or anything that holds benefit or value to an owner. Working capital, also known as net working capital (NWC), and operating capital, can tell you how much capital is readily available to meet existing expenses. It can also be useful for businesses to measure their short-term financial health. The amount of operating capital you have may affect long-term growth, paying employees, paying suppliers, and more.
How to Measure Working Capital
Working capital is a financial metric that is calculated by subtracting current liabilities from current assets. Current liabilities are all liabilities due within a year of a balance sheet date which may include accounts payable, taxes, wages, interest payable, and more. Current assets include cash, inventory, accounts receivable, short-term investments, and other liquid assets that can be converted into cash within a year of the balance sheet date. All components of a business’s capital can be found on their balance sheet. The formula for calculating working capital is as shown below.
How to Calculate Operating Capital
Formula: Working Capital = Current Assets – Current Liabilities
As an example, if a company has current assets of $80,000 and current liabilities of $60,000, then their working capital is $20,000. This means this company has $20,000 at their disposal, if they need extra capital for any reason. This is also a positive working capital, meaning this company has greater assets than liabilities. When this is the case, a business has more resources to cover any short-term debt they may be in. If a business’s capital is negative, this means their current assets do not cover all of their current liabilities. This may also show poor short-term financial health and low liquidity.
Constraints of Working Capital
The calculation of working capital is intended to be helpful for a business to determine their financial short-term health. However, capital is always changing. By the time it is calculated, it is very possible that the position has already changed. Another constraint is the relationship with cash flow. If a business is experiencing negative cash flow due to decline in revenue, this may draw down operating capital.
Working Capital Management
The management of capital is a financial strategy to ensure it is positive and is being optimized properly. To do this, financial ratios can be used to manage and assess. Current ratio, also known as working capital ratio, is calculated by dividing current assets by current liabilities. If this ratio is less than one, it means a company is not generating enough cash to pay past debts in the coming year. A ratio between 1.2 and 2.0 represents that a business is effectively using their assets.
Lastly, a ratio of over 2.0 indicates a business is not reinvesting their funds to generate revenue and is keeping a large portion of their short-term assets. Another ratio that is used to see if a business is effectively managing their operating capital is through average collection period. This ratio represents the number of days a business takes to receive payment after a sale. On the other hand, to see how effectively a business manages inventory to meet demand, inventory turnover ratio can be used.
There are many options for a company to increase their capital and ensure it is positive. This is important for a business that wants to cover existing expenses or have a safeguard for unexpected expenses.
Some options may include:
- Analyzing and reducing current expenses and liabilities.
- Taking on long-term debt to increase current assets.
- Manage inventory better.
- Refinance short-term debt as long-term debt to reduce current liabilities.
- Sell illiquid assets for cash.