How to Use the Working Capital Formula (With Examples)
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When businesses need money to cover everyday or sudden expenses, they often use their working capital. The working capital formula is a process companies can use to determine the amount of accessible capital they have available and what expenses they account for. Understanding this formula and what it's for can help business owners and accounting professionals better understand the financial health of a company and how to calculate crucial financial information. In this article, we describe the working capital formula, how to use it, what a good working capital ratio is and provide some examples for context.
What is the working capital formula?
The working capital formula is a mathematical formula for determining a company's available cash for everyday expenses. Companies and accounting professionals use this formula to measure expenses against current capital resources to provide a more accurate estimate of the company's funds. Here's the formula:
Working capital = Current financial assets - Current liabilities
To determine working capital, a company first determines its current assets and current liabilities. To better understand a company's liabilities and assets, consider these common examples of each:
These are common liabilities companies consider when calculating working capital:
Accounts payable: These are any accounts the company owes in the short-term. For example, a company might owe its supplier a fee for production materials.
Bank overdrafts: If the company overdraws its own bank accounts, it might owe overdraft fees in addition to the overdrawn balance, making it a liability.
Payroll: A company's payroll is a financial liability that it meets each pay period and one that can fluctuate.
Income taxes: A company pays income taxes on any earnings it reports and considers these expenses a liability.
Rents and overhead: Overhead expenses are expenses like rent and utility bills that companies pay, typically every month.
Short-term loans: Companies also consider any short-term loans or lines of credit liabilities.
Outstanding expenses: Any outstanding expenses that a company pays are also liabilities they can cover with working capital.
Here are examples of assets companies consider when calculating working capital:
Cash on-hand: Cash on-hand is any available cash that a company has in the bank that it can access easily and quickly.
Liquid assets: Liquid assets are any assets a company can easily and quickly convert to cash if necessary, such as stocks or government bonds.
Accounts receivable: Accounts receivable are any payments a company expects from customers or other businesses, like an outstanding invoice for services.
Inventory: Any inventory of products a company has in its warehouses or other location is also an asset.
Short-term investments: Companies consider short-term investments they expect to yield a cash return in the near future to be assets.
How to calculate working capital
If you want to learn how to use this important financial formula, follow these steps:
1. Determine current assets
Determine the current assets the company has available. Add them all up and create a general estimate for your formula. For example, you might determine that a company has about $500,000 in current assets, with $25,000 in cash. Be sure to include assets like inventory. You can use a spreadsheet or accounting software to add up all of your assets. Once you determine the total assets available to the company, you can insert this number into the formula in the current financial assets slot. Here's an example of what your formula looks like with assets included:
Working capital = $500,000 - Current liabilities
2. Determine current liabilities
When you understand your financial assets, you can determine your current liabilities to complete the formula. Determine how many liabilities to include in your formula and create a total for each one. Then, add them together to create an estimate of your total company liabilities. This number is typically lower than your assets if you have a good working capital ratio. If your expenses are greater than your assets, you get a negative number when you complete the formula, which shows you how much the company owes in liabilities. Here's what the formula looks like with $350,000 in expenses included:
Working capital = $500,000 - $350,000
3. Subtract current assets from liabilities
To complete your formula, subtract your liability numbers from your assets. This creates a number you can use as your working capital estimate. For example, if you use the numbers above, you get a working capital estimate of $150,000. The company has $150,000 of available capital and can successfully meet its everyday expenses and potentially meet emergency expenses if necessary. If you get a negative number when you complete your formula, check your original estimates and then review the company's financial reports to see where the gap between expenses and assets might be.
4. Determine your working capital cycle
Once you determine your working capital, you can calculate your working capital cycle. The working capital cycle is the amount of time between the company's outgoing expenses and incoming payments, which can affect your working capital. The working capital cycle also has its own formula, which looks like this:
Working capital cycle = Inventory days + Receivable days - Payable days
Understanding this time delay helps you understand the amount of capital the company needs to cover gap, which is the working capital requirement for the business. For example, if you have 56 days for inventory and 31 days for receivable, with 24 payable days, your working capital cycle is 63 days. You need working capital to cover 63 days of expenses.
What is a good working capital ratio?
The working capital ratio for a business is simply the ratio of assets to liabilities. A good working capital ratio typically depends on the company's capital needs and goals, but generally, a positive ratio is a good ratio. If you get a negative number when you calculate working capital, it means the company owes more than it can pay. To determine your working capital ratio, you can use a formula similar to the working capital formula, which looks like this:
Working capital ratio = Current assets / Current liabilities
If you have $500,000 in assets and $350,000 in liabilities, your working capital ratio is around 1.43%. This means that you have about one and a half as many assets as you do liabilities, which is enough to cover those expenses.
When to determine working capital
There are many times when a company might determine its working capital. Typically, companies calculate this each quarter, but there are other circumstances that require this number, including:
when applying for a loan
when working with investors
when the company is losing money
when the company is reorganising its financial structures
when a company pays taxes
when a company starts operations during the startup phase
Working capital examples
Here are some examples of working capital in business and using each formula to determine the company's capital:
This example shows a company with a positive ratio:
Stirling Computers Ltd. is a computer company that reports around $1,200,000 in sales each year. The company enlists its accountant to determine its current working capital for the first quarter of the new year, so the accountant determines all of its expenses and liabilities. The company has a total of $950,000 in assets and around $625,000 in liabilities. The accountant determines the working capital ratio using the formula: Working capital = 950,000 - 625,000. This formula yields the number 325,000, suggesting the company has a current working capital of $325,000. The working capital ratio is 1.52%.
This example shows a company with negative working capital:
Shi Lu Enterprises wants to understand why it can't meet its financial obligations, so it hires an independent accountant to review its financial spreadsheets. The accountant first determines the company's liabilities and assets, which are around $1,900,803 and $1,123,000 respectively. Using the working capital formula, the accountant determines the company's working capital is at -$777,803. That's a ratio of 59%, which means the company has nearly 60% more liabilities than it does assets.
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