Working Capital Formula: How to Calculate and Interpret It

Working capital formula is a fundamental concept familiar to financial professionals. It serves as a cornerstone for assessing reveal the liquidity and solvency of an organization. In this article, Viindoo demystifies how to calculate this important data to empower businesses with the knowledge and tools to assess their financial health.

What is Working Capital?

The working capital formula is a simple calculation that determines the amount of capital available for a company's day-to-day operations. It is calculated by subtracting a company's current liabilities from its current assets. The resulting figure represents the capital that can be used to fund the company's short-term expenses.

>>>> See more: An Overview of Working Capital in Balance sheet

Working Capital Formula

The working capital formula is a simple calculation that determines the amount of capital available for a company's day-to-day operations. It is calculated by subtracting a company's current liabilities from its current assets. The resulting figure represents the capital that can be used to fund the company's short-term expenses.

Working Capital = Current Assets - Current Liabilities

Where:

• Current Assets: These are assets that are expected to be converted into cash or used up within one year. They include items like cash, accounts receivable (money owed by customers), inventory, and other short-term assets.
• Current Liabilities: These are obligations and debts that are expected to be settled within one year. They may include accounts payable (money owed to suppliers), short-term loans, accrued expenses, and other short-term liabilities.

Positive vs Negative Working Capital

The result of the working capital formula can be either positive or negative:

• Positive Working Capital: When current assets exceed current liabilities, it indicates that the company has sufficient resources to meet its short-term obligations. This is generally considered a sign of financial stability.
• Negative Working Capital: When current liabilities exceed current assets, it suggests that the company may struggle to meet its short-term obligations with its existing resources, potentially indicating liquidity problems.

Comparing Working Capital Ratios

Aside from using the working capital formula to evaluate your company's financial health, it is also helpful to compare your working capital ratio with other companies in the same industry. This can give you a better understanding of your company's standing and highlight areas for improvement.

For example, if your company's working capital ratio is lower than others in the industry, it could indicate that you have too much inventory or are not collecting on accounts receivable in a timely manner. On the other hand, a higher working capital ratio may suggest that you are not investing enough in growth opportunities or are not taking advantage of credit terms from suppliers.

Examples of Working Capital Formula

Let's take a look at some real-life examples of how the working capital formula can be used.

Example 1: Company A

Company A has \$200,000 in current assets and \$150,000 in current liabilities. Using the working capital formula, we can calculate their working capital as follows:

Working Capital = \$200,000 - \$150,000 = \$50,000

This means that Company A has \$50,000 available to fund its daily operations.

Example 2: Company B
In comparison, Company B has \$250,000 in current assets and \$300,000 in current liabilities. Their working capital would be calculated as follows:

Working Capital = \$250,000 - \$300,000 = -\$50,000

This result indicates that Company B may have trouble meeting its short-term obligations and may need to re-evaluate its financial management strategies.

Other Working Capital Calculations

Apart from the basic working capital formula, there are several variations and other working capital calculations that can provide additional insights into a company's financial health and liquidity. These include:

Net Working Capital:

• Net Working Capital = Current Assets - (Current Liabilities + Short-term Debt)
• Net working capital takes into account the company's short-term debt in addition to current liabilities. It provides a more conservative measure of liquidity by considering the impact of debt on working capital.

Gross Working Capital:

• Gross Working Capital = Total Current Assets
• Gross working capital represents the total current assets a company holds without considering any liabilities. It provides an overview of a company's total liquidity but does not account for obligations.

Operating Working Capital:

• Operating Working Capital = (Operating Current Assets - Operating Current Liabilities)
• Operating Working Capital focuses on current assets and liabilities directly related to a company's core operating activities. It excludes non-operating assets and liabilities, providing a more relevant picture of day-to-day liquidity.

Permanent Working Capital:

• Permanent Working Capital = Minimum Working Capital Required
• Permanent working capital represents the minimum level of working capital required to support a company's ongoing operations. It can help determine a company's baseline liquidity needs.

Temporary Working Capital:

• Temporary Working Capital = Peak Working Capital Requirement - Permanent Working Capital
• Temporary working capital represents the surplus working capital needed to cover seasonal or short-term fluctuations in current assets and liabilities.

Quick or Acid-Test Ratio:

• Quick Ratio = (Current Assets - Inventory) / Current Liabilities
• The quick ratio assesses a company's ability to meet its short-term obligations without relying on the sale of inventory. It's a more stringent measure of liquidity.

How to calculate Working Capital in Viindoo?

Viindoo Accounting, automated accounting software for small and medium enterprises, will helps you calculate working capital data, you won't need to manually perform any calculations. Instead, you can simply review the balance sheet, based on the data for current assets and current liabilities that have been collected in the balance sheet.

Viindoo Accounting automates balance sheet report

Where current assets have been collected from:

• Cash and Cash Equivalents: This includes your company's cash in hand, in banks, and short-term investments that can be quickly converted to cash. Transactions involving cash and bank accounts are recorded in your financial system, and Viindoo Accounting aggregates these balances.
• Accounts Receivable: The balances of money owed to your company by customers are recorded in the accounts receivable account. Viindoo Accounting should automatically collect this data from your sales and invoicing records.
• Inventory: The value of your inventory is tracked in your accounting software as you purchase and sell goods. Viindoo Accounting should be gathering this information from your purchase and sales records.
• Other Current Assets: This category may include prepaid expenses and other short-term assets. Viindoo Accounting collects data from relevant accounts or entries related to these assets.

>>>>>> See more: What Are Current Assets Balance Sheet And How To Calculate

Current assets in balance sheet of Viindoo Accounting

Same with Current Liablilites. This figures has been collected from:

• Accounts Payable: Viindoo Accounting will collect data related to amounts your company owes to suppliers, vendors, or creditors for goods and services received but not yet paid. This account is a common source of data for current liabilities.
• Accrued Liabilities: In the system, data for accrued expenses, such as accrued salaries, wages, and taxes will be collected to represent obligations that have been incurred but not yet paid.
• Income Tax Payable: data on the income taxes your company owes but has not yet paid. The amount is often based on your company's taxable income.
• Other Current Liabilities: General category for other short-term obligations that don't fit into the above accounts, such as customer deposits, warranty liabilities, or other similar items.

>>>>>> See more: List of liabilities on a balance sheet

Viindoo Accounting software will provide you with an up-to-date and accurate balance sheet, making it easy to calculate your working capital for a more in-depth analysis of your company's financial health and to understand the implications of your working capital figure on your business operations.

15 DAYS FREE TRIAL

Viindoo automates asset depreciation calculations for seamless financial management.

FAQs

What is a good working capital ratio?

A good working capital ratio varies by industry, but a ratio of 1.2 or higher is generally considered healthy.

Having negative working capital means that a company's current liabilities exceed its current assets. This can indicate financial stress and may lead to cash flow problems and difficulty meeting obligations.

Yes, having too much working capital can be a sign that a company is not investing enough in growth opportunities or is not taking advantage of credit terms from suppliers.

Working capital should be calculated at least quarterly to monitor changes and identify potential issues.

Yes, two other formulas commonly used to measure liquidity are the current ratio and the quick ratio.

Conclusion

In conclusion, the working capital formula is a vital tool for understanding a company's short-term liquidity and financial health. It provides valuable insights into a company's ability to meet its short-term obligations and gives stakeholders a better understanding of its financial standing. By using this formula and following sound working capital management practices, businesses can ensure their short-term operations run smoothly and position themselves for long-term success.

Jun Nguyen November 29, 2023