Working capital is cash and easily cashable assets to finance the day-to-day operations of a company. With knowledge of working capital, you will be able to manage your business well and make sound investment decisions.
By calculating working capital, you can also determine whether the company is able to pay off its short-term liabilities and for how long. Companies with or without working capital restrictions will have problems going forward.
The working capital calculation is very useful in assessing whether a business is performing well enough to use a company’s resources. X Research Source Working capital formula:
#1. working capital calculation
1. Calculate the amount of working capital. Current assets are the company’s assets that can be converted into cash within a year. These assets include cash and other short-term accounts. Accounts included in current assets include trade receivables, prepaid expenses and inventories.
- This information is usually presented on a company’s balance sheet, along with a “current assets” statement.
- If the balance does not show the amount of working capital, read it line by line. Add up all the accounts to find the numbers that match the definition of current assets. You can add “accounts receivable”, “inventory”, “cash” and other accounts that fall into the “cash” category.
2. Calculate the current loan amount. Current liabilities are liabilities that mature within one year. Accounts included in current liabilities include accounts payable, accrued accounts payable and notes payable.
- The balance sheet should reflect the amount of current debt. If not, you can add current accounts payable to the balance sheet, such as “business accounts payable”, “tax debt” and “short-term debt”.
3. Calculate the amount of working capital. This calculation is done by simple subtraction. Subtract current assets from current liabilities.
- For example, a company has current assets of $50,000 and current liabilities of $24,000,000. According to the above formula, the working capital of this company is 26,000,000 rupees, which can be used to pay off current debts, while leaving more money than working capital to pay for other needs. Additional funds may be used to fund operations, repay long-term debt, or distribute to shareholders.
- If current liabilities exceed current assets, this means that there is a working capital deficit. A shortage of working capital can be a sign of a company’s insolvency and can be overcome by raising long-term debt. This situation indicates a problem in the company and is not the right investment option.
- For example, a company has current assets of Rs 100,000,000 and current liabilities of Rs 120,000,000 resulting in a working capital deficit of Rs 20,000,000. In other words, the company will not be able to repay its short-term debt and will be forced to convert its fixed assets into rubles. Will have to sell for 20,000,000 or look for other sources of funding.
- To continue operating while paying off debt, companies can apply for debt restructuring if they are at risk of bankruptcy.
#2. Understanding and Managing Working Capital
1. Calculate the current liquidity ratio. To learn more about a company’s health, analysts use an indicator of financial health called the current ratio. The current ratio is calculated using the same figures as the working capital calculation described earlier, but the result is a ratio, not Rs.
- A ratio is a comparison of two numbers. The ratio is calculated by simple division.
- To calculate the current ratio, divide current assets by current liabilities. Current liquidity ratio = Current assets: Current liabilities.
- Using the same example, the company’s current ratio is 50,000,000: 24,000,000 = 2.08. A coefficient of 2.08 indicates that the company’s current assets exceed its current liabilities by 2.08 times.
2. Know the meaning of the relationship. The current ratio is used to assess a company’s ability to repay its current debt. In a nutshell, this ratio indicates how much capacity a company is able to pay on its bills. The current ratio is commonly used to compare a company’s financial position with that of other companies or industries.
- The most ideal current ratio is 2.0. Companies with a low current ratio or below 2.0 may face a higher risk of insolvency. On the other hand, a current ratio greater than 2.0 indicates that management is overly cautious and sub-optimal in pursuing business opportunities.
- In the same example, a current ratio of 2.08 indicates a healthy financial position for the company. In other words, current assets can finance current liabilities for two years, provided that the amount of the loan remains the same.
- What is considered a good current ratio depends on the industry. Some capital-intensive industries require more borrowed funds to finance their activities. Manufacturing companies usually have high current liquidity ratios.
3. Working capital management. A business manager needs to know all the aspects that affect working capital so that he can properly manage it, such as inventory, receivables and payables. He must also be able to assess the profitability and risks arising from a shortage or excess of working capital.
- For example, a company that lacks working capital may not be able to repay short-term debt, while an excess of working capital can also be a problem. Companies with large working capital can make investments to increase productivity in the long run. For example, excess working capital can be invested in new production facilities or expand the distribution network by opening new stores. These investments can increase your income in the future.
- If the working capital ratio is too high or too low, consider the following suggestions to improve it.