Starting a new business is tough, and it’s important for entrepreneurs to regularly evaluate the financial health of their company, especially during its first few years. One way to do this is by looking at working capital.
Working capital and working capital ratio provide a way to evaluate whether or not a business can pay off its short-term debts.
But, formulas and ratios can be overwhelming. So, let’s unpack the meaning of working capital and explore what it’s used for.
Working capital is a way for businesses to see if they have the ability to pay off their current liabilities. What are current liabilities? Well, they're a business’ debts that must be paid within one year. Common examples include:
- Accounts payable
- Short-term loans
- Sales taxes payable
- Income taxes payable
- Payroll taxes payable
- Interest payable
- Accrued expenses
These debts are paid using current assets which are usually cash or assets that turn into cash within one year. Current assets include:
- Accounts receivable
- Prepaid expenses
- Investments or cash equivalents (i.e., treasury bonds, publicly traded stock, mutual funds, etc.) that can be easily liquidated
The amount of working capital a business has indicates business liquidity. And how liquid you are demonstrates your ability to convert assets into cash to pay liabilities and debts.
Defining these terms gives us a clearer picture of working capital and how to use it. So, what is it, exactly?
Working Capital Definition
Working capital is the dollar amount left over after current liabilities are subtracted from current assets. It’s used to determine if a business has enough assets to pay debts due in one year.
The working capital formula is used to calculate the money available to pay these short-term debts.
Working Capital Formula
Working Capital = Current Assets - Current Liabilities
If there are excess current assets, the additional resources can be spent on day-to-day operations. This is a great sign for the business and might indicate some flexibility in the use of your resources.
Net Working Capital
Net working capital and working capital can be used interchangeably. The formula for net working capital is:
Net Working Capital = Current Assets - Current Liabilities
The net working capital formula is used to determine a business’ ability to pay its’ short-term financial obligations. Positive net working capital indicates there are enough current assets to cover current liabilities when they’re due.
Let’s say a small business has $50,000 in current assets and $20,000 in current liabilities. Its net working capital is $30,000. Once net working capital is calculated, the business owner can take a deeper look at assets and liabilities to determine if any operational adjustments or improvements are needed.
Operating Working Capital
Operating working capital is a variation of working capital. The main differences are operating working capital is calculated differently and fewer current assets are used. It’s calculated using the following formula:
Operating Working Capital = Current Assets (Accounts Receivable + Inventory Value) - Current Liabilities (Accounts Payable)
Rather than looking at all current assets, operating working capital looks specifically at accounts receivable and inventory value. This calculation provides a current snapshot of performance and financial health.
Working Capital Ratio
The working capital ratio -- or current ratio -- is used to calculate a business’ ability to pay its current assets with its current liabilities. It’s also a great measure of overall operational health.
Working Capital Ratio
Working Capital = Current Assets ÷ Current Liabilities
Below are ranges used to evaluate a working capital ratio:
- < 1.0: Negative working capital that demonstrates potential liquidity problems
- 1.2 and 2.0: Good working capital ratio
- > 2.0: Working capital that might indicate excess assets that could be used to generate more revenue
When using the working capital ratio, there are some important factors to keep in mind. Inventory is a current asset that can be difficult to liquidate in the short term. The ratio might be misleading if the business’ current assets are primarily inventory.
If a business is drawing funds from a line of credit, the ratio might appear lower than expected. Why? When a business uses a line of credit, it’s common for cash balances to be low. Funds are typically replenished when it’s time to pay for liabilities.
In this case, the working capital ratio might reflect negative working capital. Don’t be alarmed. With a business line of credit, it’s unlikely your business will have difficulty paying liabilities.
Managing working capital is important for building and maintaining positive relationships with suppliers and lenders. It provides an overview of your business’ financial health, and it’s an excellent indicator of when adjustments in resources and operations should be made.