Working capital: How to calculate it and why it’s important

Working capital is one of the metrics to measure your business’ short-term liquidity and financial health. It shows how well your current assets can keep operations going and cushion unexpected financial obligations. There’s also a closely related metric called net working capital, which has a narrower definition.

Let’s explore what working capital is, how it’s calculated, and the pros and cons of using this metric to analyze your business’ financial health. We’ll also look into what positive and negative working capital says about your business and how you can improve your working capital.

What is working capital?

Working capital is the amount of money a business has to meet its short-term obligations. It’s calculated by subtracting current liabilities from current assets. Think of it as the cash you have on hand to pay bills, purchase inventory, and cover unexpected expenses.

While businesses can typically expect customer payments as a regular source of cash assets, there’s always the possibility of getting paid late. That’s why looking at working capital is important, as it indicates how well your business can sustain its day-to-day operations.

Why does working capital matter?

Working capital is pivotal to a business's long-term growth. For example, having positive working capital can attract investors, as it shows the business's ability to run its daily operations and pay off its short-term debts. Sustaining positive working capital can make investors more confident in the business’s growth and earning potential, which may bring in more investment.

In comparison, net working capital gives a more focused view of the business’s operational liquidity. Investors can use this metric to assess whether a company can maintain its daily operations without seeking new funds.

Business owners can also use working capital and net working capital to guide strategic decisions, such as where to invest their money. If your business has positive working and net working capital, it suggests it is financially stable and can meet its contractual obligations. This can help you negotiate favorably with suppliers.

Working capital vs net working capital: What’s the difference?

Working capital and net working capital are sometimes used interchangeably, as they both represent a business’s ability to operate efficiently while paying off its debts. However, there’s a slight difference in how they’re calculated and what they are used to measure.

Working capital formula

Working capital is the difference between a company's assets and liabilities within 12 months. The formula is:

Current assets - Current liabilities = Working capital

Let’s say your total current assets equal $740,000. This amount includes cash, finished inventory, raw materials, and accounts receivables. Your current liabilities equal $405,000. This amount might be for employee wages, business taxes, office rent, utilities, subscriptions, and debts due within the year.

Based on the formula above, your working capital would total $335,000. This is a positive working capital. If your working capital is negative, it means your business likely needs external funding, such as a bank loan, to cover short-term debts.

Net working capital formula

Net working capital is also calculated as the difference between current assets and liabilities. The actual formula changes depending on what businesses are trying to measure.

For example, ABC Manufacturing wants to assess how well it can cover operational costs without relying on cash reserves or short-term loans. The net working capital formula would exclude these non-operating assets and liabilities:

(Current assets - Cash) - (Current liabilities - Short-term debts) = Net working capital

If ABC Manufacturing wants to assess how quickly it can meet its short-term obligations with more liquid assets, such as cash and receivables, the formula would then exclude inventory, which is often less liquid:

(Current assets - Inventory) - Current liabilities = Net working capital

This measure would be useful when a business needs to know its immediate liquidity, especially in times of economic uncertainty, when converting inventory to cash, which would take more time and effort.

How to calculate working capital

To calculate your working capital, you’ll need to know your current assets and liabilities.

Current assets

Current assets refer to a business’s cash and the assets that can be converted into cash within 12 months.

When you look at a company's balance sheet, you’ll find its liquidity, with each asset having a unique liquidation amount.

Here are examples of current assets:

• Cash: This includes physical currency, funds in bank accounts, and undeposited customer payments (checks, electronic payments, etc.).

• Accounts receivable: This is money owed to the business by customers who have purchased goods or services on credit. This excludes payments that may never be collected.

• Notes receivable: A note is a formal agreement where a customer, supplier, or third party owes the business money, usually because of a loan. Short-term notes are expected to be paid back within a year.

• Other receivables: These include money owed to the business outside of normal sales activities, such as employee cash advances, insurance claims, or income tax refunds.

• Short-term investments: This includes investments that the business intends to sell within 12 months, such as stocks, bonds, or other securities that can be easily converted into cash.

• Marketable securities: This includes financial instruments such as money market funds, government bonds, or treasury bills that are easily tradable and can be converted into cash quickly, usually within 12 months.

• Inventory: This includes raw materials, work-in-progress goods, and the business's finished products for sale.

• Prepaid expenses and advance payments: These refer to payments made in advance for goods or services that'll be consumed or delivered in the future. Examples include prepaid insurance, rent, or advance payments for future inventory purchases.

Liabilities are on a separate part of the balance sheet, where you’ll see short-term debts that the business should pay off within 12 months. These liabilities usually refer to payments owed to suppliers, taxes, any financial charges, and more.

Here are examples of current liabilities:

• Accounts payable: This is money the business owes suppliers for goods or services purchased on credit.

• Notes payable: These are formal loan agreements that the company must pay back within 12 months.

• Taxes payable: This refers to taxes the company owes but hasn’t yet paid, such as income tax, sales tax, property tax, and other government levies.

• Wages payable: This is money owed to employees for work they’ve already performed but haven’t been paid yet.

• Loan interest payable: This refers to interest accumulated for outstanding loans that the company must pay in the short term.

• Loan principal due within one year: This refers to the portion of a long-term loan due within the next 12 months. Even if a loan has a long-term maturity, any amount due in the near term is classified as a current liability.

• Variable accrued expenses:​​ These are expenses incurred that the business hasn’t yet paid, such as utility bills and rent. The amount fluctuates monthly based on usage or consumption.

• Deferred revenue: Payments received from customers for goods or services that the business has yet to deliver. For example, if a customer prepays for a service contract, the company holds this money as a liability until the service is delivered. Once delivered, the money is regarded as revenue.

Benefits of assessing working capital

Let’s look at how a good understanding of your business’s working capital can benefit you.

Improve liquidity

Working capital management is important for maintaining liquidity. It involves tracking your business’ accounts payable and receivable, inventory, and debt. This helps you ‌manage your cash flow to ensure there’s enough money to pay short-term debts and operating costs.

Supports continuous operations

Adequate working capital lets your business operate without interruptions. Understanding your working capital helps you make informed decisions on where to allocate resources. For example, after using the money collected from customers to pay for operational costs, do you spend the remaining on growth initiatives or save them to buffer potential bills?

Limitations of assessing working capital

Here, we’ll examine some limitations of using working capital to assess your business’s financial health.

Focuses only on monetary aspects

Working capital focuses on items of monetary value, such as finished goods, debts, receivables, and more. This limited focus overlooks non-monetary factors such as economic downturns or regulatory changes that might impact the business’s financial health.

Lacks situational flexibility

Working capital is considered a static metric because it only captures a snapshot of a business’s financial health at a particular moment. This limitation can obscure the real-time impact of fluctuating market conditions on profitability.

Positive vs negative working capital

Positive working capital is a sign of good financial health. It shows that a business can pay off short-term debts and operational costs. The excess assets suggest that the business can invest in growth and handle unexpected expenses.

Negative working capital may then indicate poor financial health and liquidity issues. Businesses with negative working capital may struggle to repay loans and may have to seek external funding or conduct cost-cutting measures to cope. But it's important to note that negative working capital isn't always bad. It can be typical in industries like retail or fast food, where companies can turn over inventory and generate cash rapidly. Still, it generally suggests a need for better cash management or operational adjustments.

How to improve your working capital

You can improve your working capital in two ways: Increase current assets and reduce current liabilities.

Increase current assets

One way to increase your current assets is to take on long-term debt. The word “debt” might seem counterintuitive. However, long-term debt increases your cash reserves in the short-term without significantly increasing your current liabilities, as the repayment is spread over a longer period.

Another way to increase your current assets is to sell non-liquid assets for cash. More cash means more working capital.

Reduce current liabilities

You can refinance your short-term debt into long-term debt to reduce your current liabilities. This adjustment extends the repayment period beyond the upcoming 12 months, which helps to reduce your current liabilities‌.

Avoid holding excessive stock in your inventory to minimize wastage and unnecessary storage costs. This helps to reduce your overall expenses, thus reducing your current liabilities.

Furthermore, automating your financial operations can help reduce overhead costs. For example, fintech solutions can automatically create invoices for your suppliers, saving you time from manual data entry. This reduces staffing costs and potential loss from data entry mistakes.

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