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How to Calculate the Right Amount of Working Capital

Last updated on April 8, 2021

Jacques Famy Jr

While it’s likely you as a business owner don’t talk about working capital every day, it’s a standard accounting term that may help your company succeed. Working capital affects various business operations, from making payments on a short-term business loan or other bills and providing salaries for your employees to supporting internal expansion opportunities and more. It’s recommended to regularly calculate your company’s working capital as the final number gives you a realistic perspective on whether you currently have enough funds available to meet the current, short-term obligations mentioned above. An accurate calculation of your working capital will help you predict your company’s future needs and help you plan so you always have enough funds available.

Understanding the Importance of Working Capital

The term working capital refers to the difference between a company’s current assets and liabilities. When working capital is calculated, the outcome resembles a specific company’s ability to pay current liabilities with its current assets. Companies with good financial standing should have enough working capital to pay their bills for one year and enough resources necessary for internal expansion. Studying your company’s working capital can help you predict potential future financial obstacles, so you can take adequate steps to prevent these issues altogether. Likewise, if a company has negative working capital, it means that the business does not have enough liquidity to pay bills for a year or support internal expansion.

Necessary Financial Components

The financial components that equate to working capital are your current assets and liabilities. But you’re probably curious as to what these two terms refer to exactly. Current assets, both tangible and intangible, are what you as a company currently own that can quickly be turned into cash within one year or one business cycle – whichever comes first. Since current assets need to be converted into cash relatively quickly, it’s important not to include long-term or illiquid investments in this bucket. Similarly, current liabilities are the debts and expenses you as a company expect to pay within the same year or business cycle. Here are some examples of what current assets and liabilities can be when you initially begin calculating your working capital:

  • Current assets: Checking and savings accounts, stocks, bonds, mutual funds, exchange-traded funds (EFTs), money market accounts, accounts receivable, cash and cash equivalents, inventory, etc.
  • Current liabilities: Rent, utilities, materials and supplies, interest or principal debt payments, accounts payable, accrued liabilities, accrued income taxes, dividends payable, capital leases, etc.

Steps to Calculate

By determining your working capital ratio, you can get an idea of your company’s short-term financial health. Below is the general formula used to calculate your current working capital ratio:

Current Assets / Current Liabilities = Working Capital Ratio

For example, if your company has current assets of $2 million and current liabilities of $700,000, your working capital ratio is 2.86. It can also be worthwhile to calculate your current net working capital as this tells you the funds you have readily available to meet current expenses. Below is the general formula used to calculate your current net working capital:

Current Liabilities – Current Assets = Net Working Capital

You must remember that only your short-term assets and liabilities are considered when making calculations for both working capital ratio and net working capital. Short-term assets can include the cash currently in your business bank account, accounts receivable, inventory that will transform into cash within the next year, and more. Short-term liabilities can include accounts payable, additional debts, accrued expenses for employee salaries, taxes, and more.

Does Working Capital Change?

Over time, it’s not unusual for your company’s working capital figure to change as your current assets and liabilities are based on a continuous 12-month timeframe. In fact, the exact working capital figure can change each day with consideration to your company’s debt. Long-term assets and liabilities, like long-term business loans, real estate, or equipment, can quickly turn current due to repayment deadlines, potential buyers, and more. Various scenarios can cause your working capital to change, such as:

  • Credit policy: If your company tightens its credit policy, the number of outstanding accounts receivable will be reduced, thus freeing up cash. However, net sales may be reduced as a result.
  • Collection policy: By altering your collection policy to a more aggressive manner, you can gather more collections quickly, which reduces the number of outstanding accounts receivable.
  • Inventory planning: Should you decide to increase your company’s inventory levels to improve order fulfillment, the overall inventory investment with increase by using cash.
  • Purchasing practices: Unit costs can be reduced by purchasing in bulk, which increases the investment in inventory by using cash.
  • Accounts payable payment period: At times, companies negotiate with suppliers to agree upon a more extended payment period. While this is a source of cash, suppliers may decide to increase prices as a result.
  • Growth rate: As a company grows, more funds are invested into accounts receivable and inventory. If business growth occurs quickly, working capital changes can be drastic because of the high volume of cash used.
  • Hedging strategy: Hedging techniques can be utilized to generate offsetting cash flow, meaning there are fewer unexpected changes in working capital. However, it’s important to remember that transactional costs will likely appear with the hedging transactions in particular.

Ways You Can Boost Your Working Capital

It’s not unusual for companies to reach a point where they require additional working capital, and this need can occur for various reasons. Below is a brief overview of reasons why you as a company owner might need to boost your working capital:

  • A company’s cash flow can change by season, and this isn’t uncommon. If this is normal for your company, you may need additional working capital to gear up for a busy season or keep the business operating smoothly when less money is coming in. Start by calculating your operating cash flow by quarter to determine whether you need additional working capital.
  • Nearly all businesses run into the issue of needing additional working capital to fund obligations to supplies, employees, and the government – especially when waiting on payments from customers.
  • Additional working capital can improve your business by enabling you to take advantage of bulk purchase discounts from suppliers.
  • Additional working capital can be used to pay temporary employees, cover project-related expenses, and more.

If you need additional working capital, there are a variety of funding options, each with its own benefits. An unsecured, revolving business line of credit is an excellent solution for financing temporary working capital needs. Lines of credit have terms that are more favorable than a business credit card, and you can withdraw only as many funds as you need at any given time. Similarly, business credit cards are convenient for incidental expenses; however, it’s easier for excessive debt to accumulate. There are also higher interest rates and higher fees for cash advances.

Final Thoughts

Understanding your company’s working capital needs can be complex, but determining these calculations can help you operate smoothly in the current market and adequately prepare your business for future growth and success. If you’re prepared to calculate your working capital ratio and net working capital, it’s highly recommended to seek advice from a small business financial advisor as they can help you better understand your company’s unique needs and identify steps for ultimate business success.

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