What is working capital and how do you calculate it?
Working capital is a measure of a company’s financial health and shows the difference between current assets and current liabilities. It demonstrates liquidity and operational efficiency, and the potential for a business to invest in growth and expansion as well as meeting its current financial obligations.
It’s calculated by taking all current assets and liabilities into account, which includes elements such as cash, stock inventories, and raw materials, as well as interest on debts, taxes, and supplier bills.
Key points about working capital:
- Working capital is the amount a company has available to cover its everyday operations as well as invest in future growth.
- Working capital can be calculated by dividing a company’s current assets by its current liabilities.
- It’s a measure of short-term financial health that shows liquidity and operational efficiency, though can also highlight potential problems if it’s consistently very high.
How to calculate working capital
Working capital can be calculated by dividing current assets by current liabilities, giving a number known as the current ratio. If this ratio is above 1.0, current assets are greater than current liabilities.
For example, if a furniture manufacturer has current assets valued at £600,000, including its cash, showroom stock, customer accounts etc, and current liabilities of £450,000, including the cost of utilities and wages at its factory, taxes, and supplier invoices, then it’s working capital can be expressed as a current ratio of 1.3.
This means the company has a healthy working capital for future production expansions or for entering new markets.
Current assets include everything a company owns that can be easily converted to cash within a standard business cycle, usually the financial year. This includes cash in accounts as well as customer invoices, stock and other tangible inventories, as well as easily liquidated assets such as bonds and shares.
Current liabilities are made up of all the debts and expenses a business is expected to cover within a financial year or business cycle. This includes everyday operational costs such as rent and utilities, raw materials and other supplies for production, as well as interest payments on debt, bills owing to suppliers, and tax payments.
Understanding working capital
It’s important for a business to know its working capital so it can understand its potential for growth as well as its ability to cover short-term debts and commitments. Any new project will need an investment in working capital, whether that’s expanding to new markets or increasing production capacity.
A financially healthy business will have the ability to pay off its current liabilities with its current assets and fund its everyday operations without eating into its working capital. However, it’s also worth remembering that a business with a consistently high working capital might indicate problems such as an excess of stock or a lack of investment in growth.
The actual figure of working capital will change over time, due to the nature of the 12-month business cycle. Debts will come due, property will be bought or sold, machinery will be invested in – it all affects the exact working capital figure. This is why working capital should be assessed over time rather than looked at day-to-day.
Working Capital FAQs
How do you calculate working capital?
To calculate the working capital of a business as a monetary amount, simply subtract all current liabilities from current assets. For example, a company with current assets of £100,000 and current liabilities of £90,000 has a working capital of £10,000. Or you can calculate it as a ratio by dividing current assets by current liabilities.
Why is working capital important?
Working capital is an important metric for a business to know as it demonstrates solvency and the ability to invest in future growth. Even if a business shows profitability every year, it could still go bankrupt if it has no working capital.
What is a good working capital?
In general, a healthy working capital will be over 1.2, though this can be different depending on the type of business and the industry. A consistently high working capital could also highlight a lack of investment or mismanagement of stock inventory, so further analysis is needed to get more thorough financial picture.
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