Working Capital

There are many different balancing acts businesses need to master. You’re constantly trying to keep things in check like revenue versus expenses or supply and demand.

One key balancing point that can sink or swim a business is assets versus debts.

In some cases, taking on debt is necessary for starting or growing a business. So long as you’re equipped to cover the payments, it’s a practical tool that helps many entrepreneurs afford investment in their business that’s otherwise unachievable.

So how do you know if your business has found the balance point between its debt and assets? You need to understand working capital.

What Is Working Capital?

Working capital measures how effectively a business can pay down its debts. It’s calculated by subtracting your current liabilities from your current assets.

A positive working capital means your business has enough assets to pay down its debts and have money left in the bank. On the flipside, a negative working capital means there’d still be debt left over.

How to Calculate Working Capital

To calculate working capital, you need to look at your current assets and liabilities. Then simply put them into this equation:

Working Capital Formula

Working Capital = Current Assets – Current Liabilities

All of the information you need to calculate your working capital is found on your balance sheet.

Calculating working capital isn’t as easy as taking your total assets and subtracting your total liabilities, though. The formula uses current assets and current liabilities only. Let’s dig into what those are and why we single those out.

Defining Current Assets and Current Liabilities

Current assets are assets that can be converted into cash within a year. Similarly, current liabilities are debts that are to be paid within a year.

Examples of current assets include:

  • Your total cash balance
  • Inventory
  • Any outstanding accounts receivable

Examples of current liabilities include:

  • Accounts payable
  • Credit card debt
  • A year’s worth of scheduled payments for long-term debts like loans or mortgages

Why do we only include current assets and current liabilities when calculating working capital?

Think about some of the assets you might have on your balance sheet—something like property, plant, and equipment (PP&E) isn’t easily turned into cash.

Working capital focuses on the ability of a business to pay down its debt on a short-term basis. By including long-term assets and debts, the metric starts to lose its meaning.

Is a situation where you’re liquidating all your assets realistic? Not likely.

By only looking at current assets and current liabilities, you get clearer information about the cash that will be available to cover your debts in the immediate future.

How To Find and Track Working Capital

Everything you need to know to calculate working capital is found on your balance sheet.

Since a balance sheet is segmented by assets and liabilities, with each section broken into line items, you can easily tally up current assets and current liabilities for a quick calculation.

Where it can get tricky is with long-term liabilities like loans.

For example, if you just got a $50,000 loan that’s going to be paid over 5 years, you need to know how much you’ll be paying within the first year of the loan.

This information is typically found in an amortization schedule. These are often provided with the documents you receive with the loan, mortgage, or other debt agreement.

Review the amortization schedule and tally up only the payments that are due within the next 12 months. Include both the principal and interest portions of the payment.

It’s also worth tracking working capital over time, especially if you’ve brought on new debt. By tracking how the metric is changing, you’ll catch if your ability to pay down your debts is trending in the wrong direction. Getting your working capital back on track is always going to be easier before it falls into the negatives.

Why Working Capital Is Important

Many businesses need to take on debt to invest in capital, bridge slow periods, and kickstart their growth plans. In 2021, 34% of small businesses applied for a loan citing inventory purchases, cash flow, payroll, and debt consolidations as the most common reasons.

A further 79% of small businesses have credit cards.

If you’ve taken on debt, you need to make sure you have the capacity to pay it down. Tracking your working capital helps you understand when you might be at risk of not being able to cover your payments.

There are some shortcomings with working capital. For example, if you have $8,000 in accounts receivable, $2,000 in cash, and $5,000 in accounts payable, your working capital is $5,000.

But what if the invoice due dates for your receivables come after your payables? You won’t have enough cash to cover the payments.

Treat working capital as a canary in a coal mine.

If your working capital is dropping below a certain threshold, you’ll want to start checking what you can do to shore up more cash, refinance short-term debts, or improve your cash flow management.

Even if you’re constantly recording a positive working capital, you can have an excess amount. Having high working capital means it’s time to start reinvesting those assets into your business.

How To Analyze Working Capital

The simplest rule of thumb is a positive working capital is a good thing. But of course, as with all metrics, it’s essential to understand it within its context.

For example, say two businesses have a working capital of $1,000.

One is an independent contractor that does graphic design with few assets and liabilities, the other is a manufacturer with lots of inventory and debt on its balance sheet. That working capital metric doesn’t mean the same thing to both businesses.

This is where the working capital ratio (or current ratio) comes in handy. If you want to benchmark yourself against competitors or other businesses, the ratio requires less context to be understood.

The working capital ratio tells you the proportion of assets you own relative to the debt you owe. Instead of subtracting current liabilities from current assets, the working capital ratio equation is:

Working Capital Ratio = Current Assets / Current Liabilities

In this case, you’re aspiring for a working capital greater than 1.0, which corresponds to a positive working capital. Once the ratio dips below 1, you don’t have enough current assets to cover your debts.

Let’s look at that prior example of two businesses with a working capital of $1,000.

The graphic designer has $2,000 in the bank, $5,000 in accounts receivables, and $6,000 in accounts payables. With current assets of $7,000 and current liabilities of $6,000, their working capital is $1,000 and their working capital ratio is 1.17.

The manufacturer has $10,000 in their bank account, $30,000 in inventory, $9,000 in accounts payable, and $30,000 in short-term loan payments. Their current assets are $40,000 with current liabilities of $39,000. Their working capital is $1,000 as well, but their ratio is 1.03.

Despite having the same working capital, the business with the higher working capital ratio shows a better ability to pay down its debts.

What’s A Good Working Capital Ratio?

It’s suggested that businesses should aim for a working capital ratio of 1.0 to 2.

You might think that a higher working capital ratio is always better—after all, it means you’re more set to cover your debts, right?

A high working capital ratio highlights a different problem: the underuse of assets. It means you have a surplus of assets at your disposal that aren’t being invested back into the business.

When looking at your working capital, don’t just think about how easily you can pay your debts. Think about what you can do with those assets to help grow your business.

If your high working capital ratio comes from inventory, it might be time to offer a discount to move excess stock. If it comes from cash balances, look into investments that can increase your business’s efficiency.

Making the Most Of Working Capital

Working capital is one of many metrics businesses should track to understand their business’s financial health. The best way to get value from these metrics? Spend less time calculating and more time analyzing.

Enter Finmark from BILL: a financial planning tool that helps you track essential metrics and automatically turn data into intuitive reports, dashboards, and visualizations. That means less time crunching with a calculator and more time making impactful, informed decisions.

Try a free trial of Finmark today.

This content is presented “as is,” and is not intended to provide tax, legal or financial advice. Please consult your advisor with any questions.