At a high level, working capital is the funds available to your company for use in your day-to-day operations. Without working capital, you wouldn’t be able to stay in business—so this little overview is worth paying close attention to! Working capital is also what investors will look at to assess both your company’s short-term financial health and its liquidity (aka how easily the company’s assets can be sold off and converted into cash). For businesses, working capital can be found by using a super simple formula:
Working Capital = Current Assets – Current Liabilities
What makes up your company’s current assets? If you take a look at your balance sheet, you’ll see that your current assets include cash on hand, accounts receivable, and inventory. Under the category of current liabilities, you’ll find accounts payable, accrued expenses, notes payable, and the current portion (i.e., due within the next year) of long-term debt, such as bank loans and lines of credit.
Working Capital and the Health of Your Business
When subtracting your current liabilities (aka, your company’s short-term debts) from its current assets, you want to end up with a positive amount, or positive working capital. This can be a good indication that you have the financial capacity to pay off short-term debts, whereas negative working capital means you likely don’t have that capacity.
Investors and other interested outside parties will want to get a clear idea of your company’s working capital, so that they can decide whether your business is financially healthy and whether it is being managed efficiently. Working capital is a good indicator of how your company’s inventory, accounts receivable, accounts payable, and cash on hand are being managed. If these accounts are being handled smartly (using the right accounting software) and your business is healthy, this will reflect in your working capital.
The Working Capital Ratio
Another way of using your company’s current assets and liabilities to analyze working capital is by looking at the working capital ratio. To find this ratio, all you need to do is divide current assets by current liabilities:
Working Capital Ratio = Current Assets / Current Liabilities
If the ratio is less than 1.0, indicating that the amount of liabilities exceeds the amount of assets, you’re left with negative working capital. As we saw above, that means your company could be headed for financial difficulties—the worst case scenario being bankruptcy. But having a high working capital ratio isn’t necessarily a great thing either, as it can indicate a surplus of inventory or that extra assets are not being invested into the company. So what would be an ideal ratio? Again, it varies by industry, but a working capital ration between 1.2 and 2.0 is generally agreed to be the range to aim for.
Whether your business is in the startup phase or if it’s been up and running smoothly and experiencing growth, getting a handle on your company’s working capital is an essential part of its overall financial health. And while the amount of working capital and the working capital ratio will certainly vary from company to company (and even more so from industry to industry), it is a useful tool to determine your business’ profitability and can be used to make smart, informed decisions for your business at any stage.
Want to learn more about working capital or have other questions about small business accounting? We’d love to hear from you! Drop us a line anytime at firstname.lastname@example.org.