Understanding Working Capital for Businesses
You are probably vaguely familiar with the term ‘working capital’, but do you truly understand what it means? Working capital is the measurement of a business’s capability to pay off current liabilities with its current assets.
Understanding working capital is critical to get a grasp of your business’ health, funding inventory, and plans for long-term growth. To ensure your company’s working capital is sufficient, it’s essential to understand what working capital is and why it is important.
Working Capital, Explained
Working capital can be calculated as current assets – current liabilities. It essentially measures what the company owns minus what the company owes. Working capital, sometimes referred to as net working capital (NWC), is a critical determinant of a company’s liquidity, operational efficiency, and short term financial health, and indicates whether a company would be able to pay off debts within the year.
Current assets used to calculate working capital include checking & savings accounts, inventory, accounts receivable, stocks & bonds, and mutual funds.
Current liabilities, which measure debts and expenses incurred by the company, include accounts payable, salaries, income tax, rent, and utilities.
How to Calculate Working Capital
To calculate working capital, you use the formula:
Current Assets – Current Liabilities = Working Capital
It is also important to understand your current ratio, which is measured as:
Current Assets / Current Liabilities = Current Ratio
The general rule for the current ratio is that the higher the ratio, the better. However, this is dependent on the industry that you are in. The goal with the current ratio is to sit at or above the industry average.
Types of Working Capital
If your company’s current assets are greater than your current liabilities, you have positive working capital. This suggests that your company is healthy and has high potential for growth.
However, if your current assets equal your current liabilities, you have zero working capital. For some industries, such as those with little to no inventory, this is common.
It is also possible to have negative net working capital, where your current liabilities exceed your current assets. Although this is generally not ideal, there are some industries where it is acceptable such as grocery stores and fast-food chains, which have an extremely fast inventory turnover.
Whether you are applying for a performance bond or are looking to cover short-term debt obligations, It’s important for all businesses’ to monitor their working capital. By monitoring working capital, you can increase company health and profitability over time. Additionally, you can gain insight into whether you are able to expand or should cut costs. For more information on working capital, check out the infographic below.