Working capital, also known as net working capital (NWC), is the difference between a company’s current assets, such as cash, accounts receivable (customers’ unpaid bills) and inventories of raw materials and finished goods, and its current liabilities, such as accounts payable.
Working capital is a measure of a company’s liquidity, operational efficiency and its short-term financial health. If a company has substantial working capital, then it should have the potential to invest and grow. If a company’s current assets do not exceed its current liabilities, then it may have trouble growing or paying back creditors, or even go bankrupt.
Working capital affects many aspects of your business, from paying your employees and vendors to keeping the lights on and planning for sustainable long-term growth. In short, working capital is the money available to meet your current, short-term obligations.
To make sure your working capital works for you, you’ll need to calculate your current levels, project your future needs and consider ways to make sure you always have enough cash.
The Formula for Working Capital
You can get a sense of where you stand right now by determining your working capital ratio, a measurement of your company’s short-term financial health.
Working capital formula:
Current assets / Current liabilities = Working capital ratio
If you have current assets of $1 million and current liabilities of $500,000, your working capital ratio is 2:1. That would generally be considered a healthy ratio, but in some industries or kinds of businesses, a ratio as low as 1.2:1 may be adequate.
Your net working capital tells you how much money you have readily available to meet current expenses.
Net working capital formula:
Current assets – Current liabilities = Net working capital
For these calculations, consider only short-term assets such as the cash in your business account and the accounts receivable — the money your customers owe you — and the inventory you expect to convert to cash within 12 months.
Short-term liabilities include accounts payable — money you owe vendors and other creditors — as well as other debts and accrued expenses for salary, taxes and other outlays.
Working capital that is in line with or higher than the industry average for a company of comparable size is generally considered acceptable. Low working capital may indicate a risk of distress or default.
Understanding your needs
Getting a true understanding of your working capital needs may involve plotting month-by-month inflows and outflows for your business. A landscaping company, for example, might find that its revenues spike in the spring, then cash flow is relatively steady through October before dropping almost to zero in late fall and winter. Yet on the other side of the ledger, the business may have many expenses that continue throughout the year,
Parts of these calculations could require making educated guesses about the future. While you can be guided by historical results, you’ll also need to factor in new contracts you expect to sign or the possible loss of important customers. It can be particularly challenging to make accurate projections if your company is growing rapidly.
These projections can help you identify months when you have more money going out than coming in, and when that cash flow gap is widest.
4 reasons why your business might require additional working capital
- Seasonal differences in cash flow are typical of many businesses, which may need extra capital to gear up for a busy season or to keep the business operating when there’s less money coming in.
- Almost all businesses will have times when additional working capital is needed to fund obligations to suppliers, employees and the government while waiting for payments from customers.
- Extra working capital can help improve your business in other ways, for example: enabling you to take advantage of supplier discounts by purchasing in bulk.
- Working capital can also be used to pay temporary employees or to cover other project-related expenses.