How to Calculate Working Capital
Calculating working capital is relatively simple, the formula is:
Current Assets – Current Liabilities = Working Capital
If you can do arithmetic, you can figure out your business’s working capital. What can be more difficult is knowing your current assets and liabilities. However, this information should all be on your company’s balance sheet.
The current assets of a company include its cash reserves as well as anything that can quickly be turned into cash (see cash flow vs. profit for further details). A rule of thumb is that if something can be turned into cash within twelve months, it’s counted as a current asset.
Examples of current assets are:
Current liabilities include all of your business’s outstanding bills and unpaid debts. It’s a measure of how much your company will need to spend in the immediate future to no longer owe any money to anyone.
Some examples include:
The Working Capital Ratio Formula
Some business owners look at their working capital ratio when thinking about their available working capital. This ratio measures the ratio of current assets to current liabilities.
Ratios of 1 or higher indicate that you have enough assets to cover your liabilities while ratios under 1 mean you don’t have the resources to cover your liabilities. The higher the ratio, the easier it will be for your business to cover its current liabilities, though a ratio that’s too high might indicate that you have too many assets on hand and could stand to invest in growth.
To calculate your working capital ratio, use this formula:
Current Assets / Current Liabilities = Working Capital Ratio
Example of How to Calculate Working Capital
Consider this simplified example of how to calculate working capital.
You operate a business of one. Your company has $2,000 in its checking account and recently sent an invoice to a customer for $5,000 of work. It has no other current assets, putting its total current assets at $7,000.
Your company also recently received an invoice for $1,000 from a supplier and you have a small loan for $2,500 from a local bank, putting its current liabilities at $3,500.
Your company’s working capital is $7,000 - $3,500 = $3,500 and its working capital ratio is $7,000 / $3,500 = 2.
How to Interpret Working Capital
Knowing how to calculate working capital is important, but it doesn’t have much value if you don’t know what working capital is useful for.
What Does Working Capital Indicate?
The primary value behind knowing your company’s working capital is knowing the short-term liquidity of your business. Higher liquidity means having more cash available to do things like pay employees and suppliers or invest in growth.
If your company doesn’t have enough liquidity, it might not be able to meet its financial obligations, which means missed bill payments or not making payroll. For information on overseeing your cash flow check out our article small business cash flow management.
Positive vs Negative Working Capital
Positive working capital indicates having enough current assets to meet existing liabilities. It means your business shouldn’t be in immediate danger of insolvency.
Conversely, negative working capital means having more liabilities than assets. Without outside financing, there’s a good chance your company won’t be able to pay its bills or meet the expenses of a small business.
However, having negative working capital isn’t always a bad thing in the short-term. Businesses that sell products quickly enough that sales happen before bills come due may have negative working capital. That means high-volume companies like grocers or online retailers might have negative working capital.
What Is a Good Working Capital Ratio?
What qualifies as a good working capital ratio varies from industry to industry, but in general a ratio between 1.2 and 2 is viewed as good. Lower puts you at risk of being unable to pay your bills. Higher means having more money than you need in current assets, which means missing out on investment opportunities or having high inventory costs.
Why Is Working Capital Important?
There are both benefits and drawbacks to using your company’s working capital and working capital ratio to make decisions.
Advantages of Calculating Working Capital
Limitations of Using Working Capital Ratio
FAQs about Working Capital
These are some frequently asked questions about working capital.