How to Calculate Working Capital for Your Business | The Complete Formula
If you are a small business owner, you likely have a pretty good understanding of your finances. Money that your business makes must be carefully evaluated to ensure that funding goes into the right areas. Balancing your working capital and growing your business is an art form that isn’t learned overnight. Knowing how and when to spend your business money often takes a lot of trial and error. But with diligence and research, you can learn how to execute your finances wisely and effectively. If you’re new to owning a small business or you just want to improve your efficiency, you’re going to appreciate the information we’re sharing today. Working capital is the lifeblood of your small business. As such, you need to fully understand what it is and what it means for your company. We’re going to show you how to calculate your working capital so you can better plan your business operations. At Seek Capital , we understand the importance of working capital. That’s why we’re passing this formula on to you and your business – so you can thrive and become more successful!
Assets and Liabilities
Working capital is money that’s readily available to your small business. This money is used in handling your operations for the upcoming year. But before we go any further in our guide to calculating working capital, it’s important that you have a good understanding of current assets and liabilities. Why are these important? Both current assets and current liabilities are pivotal in calculating your business’s working capital. You’re going to need to understand what they mean for your business so that you can accurately determine what your working capital is. Let’s begin with assets.
Current Assets
Current assets are simply the funding that you are expecting to use before the end of the year. Current assets consist of things like cash, inventory, marketable securities, bank accounts, accounts receivable, and even company supplies. As you can see, these are all things that are instrumental in the operations of your business. Without them, your company wouldn’t be able to run as smoothly as it does – if not at all.
Current Liabilities
Current liabilities are liabilities within your company that you expect to pay before the end of the year. Current liabilities consist of things like accounts payable items for products and services purchased paid for through accounts payable, building/warehouse rent, utility bills, and notes payable (due within the year). Working capital concentrates on your long-term assets and liabilities. As such, you can calculate operating working capital to see what your financial health looks like for the long-term.
What is Working Capital?
Working capital is any money that is readily available for your business to use toward its day-to-day operations. Knowing your working capital will give you a good indication of what your overall financial health looks like. This is because working capital consists of the following: Revenue Collection Your working capital is a reflection of what kind of revenue your business has made. What’s more, working capital will also show you how effective your revenue is collected and how it is recognized. If your revenue collection is slow, it can negatively affect your company’s cash flow. This means that you will have less to work with for paying bills associated with the operation of your small business. Inventory Management This can be a challenging aspect of business for small business owners. While it may appear to be non-threatening, managing inventory can be a real bear. There are complexities that aren’t readily evident on the surface. Ordering too much inventory can lead to less operating cash and crush your net income. When this happens, you are left with too much overhead, sitting in a big warehouse somewhere eating up your finances. And if you can’t sell these items in a reasonable amount of time, your inventory turnover ratio will be a mess. Conversely, ordering too little can also harm your bottom line. Sales are what keep your doors open, after all. Without products available to meet demand, potential customers will go elsewhere, possibly never to return. You don’t want to become known for never having anything in stock. That’s why it’s so important to get a firm grasp on your inventory and learn to manage it efficiently. Accounts Payable Accounts payable is a reflection of the main part of your current liabilities unless your business has short-term notes payable . Whether you are currently working on your financial projections for the next five years or trying to figure out your budget for the following year, your total accounts payable can give you a pretty good understanding of your business operating costs. When you have a clearer vision of these numbers, you can better plan for the following year. If changes need to be made in certain areas, you will be able to tell where and how to finance these areas for the betterment of your business. Business owners who have had experience with this know how to plan in a way that makes the best use of their available finances. If you are just starting out, this can take some time to get a handle on. But with patience and practice, you can get control of your assets and accounts payable.
Calculating Working Capital
To determine your net working capital, you want to use the following formula: Current assets - Current liabilities = Net working capital Use this formula when you want to figure out what your total working capital is. For example, let’s assume that your current assets total $100,000. Now let’s assume that your current liabilities total $80,000. The calculation would look like this: $100,000 - $80,000 = $20,000 in net working capital If you would like an accounting ratio of your net working capital, use the following formula: Current assets ÷ Current liabilities = Working capital ratio Let’s use the figures from the example above to see what the formula would look like. $100,000 ÷ $80,000 = 1.25 working capital ratio This translates to each $1 in current liabilities equaling $1.25 in current assets that are available to pay off those liabilities. While this formula is similar to the quick ratio formula, there is a difference. The working ratio formula includes your business’s inventory. This isn’t found in the quick ratio formula. The working capital ratio is designed to measure your business’s overall liquidity. This includes your ability to pay off your short-term liabilities by using your short-term assets.
Reading Between the Lines
While the working capital formula is easy enough to calculate, the end result can be used to determine a lot about the overall health of your company. For example, let’s say that you determined your working capital ratio to be less than 1. This would be an indication that your business is having serious liquidity problems and that you don’t currently have the assets to cover the cost of your liabilities. Conversely, a higher figure would be a good indication to investors that your business is doing well and is capable of paying off current and upcoming liabilities. What’s more, your working capital can tell you other pertinent things about your company. The Need to Make Changes Being a business owner, you have a lot of responsibilities. From paying for your building’s rent to ensuring that your employees are paid on time, you need to be sure that everything operates cohesively and without delay. You can use your working capital to provide you with the necessary data to let you know whether you will be able to meet those responsibilities on time. If there appear to be foreseeable issues in doing so, you will have a baseline for how to make adjustments. Liquidity You have a lot of documentation that can tell you a lot about your business. However, only your working capital can inform you about the status of your company’s liquidity . Knowing where you stand with your company’s liquidity will make it easier to make financial decisions all across the board. Business Health As we mentioned a moment ago, working capital is a great way to gauge the health of your business. This can be particularly useful for investors, as it can give them the peace of mind that your company is doing well and that you can meet your responsibilities on time.
Summary
Regardless of whether you are just starting out or you’ve been in business for years, it’s important to calculate your working capital to see where your company stands. If you need a hand with your working capital, you may be better off investing in special software that is designed to calculate your working capital for you. Many accounting software comes with this feature and will make your life much easier. For more tips on improving your business operations, be sure to check out our blog entries . We provide direction for small business owners that will help you make the most of your venture. Sources https://www.myaccountingcourse.com/accounting-dictionary/short-term-notes-payable https://www.fool.com/knowledge-center/how-to-find-total-current-assets.aspx https://www.businessinsider.com/what-is-liquidity