What is working capital? Formula and working capital management tips
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Originally Posted On: What is working capital? Formula and management tips | QuickBooks (intuit.com)
Successful managers make informed business decisions based on metrics, one of which is working capital. No business can operate without generating sufficient cash inflows, and monitoring working capital can help you get enough cash in the door each month.
You can use the components of working capital and some key financial ratios to improve your outcomes and your business’s short-term financial health. Let’s start with a definition.
What is working capital?
The definition of working capital is the capital a business uses for its day-to-day operations. Working capital, also called net working capital (NWC), is calculated by subtracting a business’s current liabilities from its current assets.
Working capital formula
Working capital = Current assets – Current liabilities
Assets and liabilities are included in the balance sheet, and you’ll use the components of the balance sheet to calculate working capital. The balance sheet is generated using a formula.
Understanding the balance sheet formula
A balance sheet is a financial statement that reports assets, liabilities, and equity balances as of a specific date.
The balance sheet formula is assets less liabilities equals equity.
Here are the components that make up a balance sheet:
- Assets are what your business owns. Assets are resources used to produce revenue. If you’re a plumber, your truck and the equipment you use are defined as assets.
- Liabilities are what your business owes to other parties. Liabilities include accounts payable and long-term debt.
- Equity is the difference between assets and liabilities, and you can think of it as the true value of your business. If you sold all of your assets for cash and used the cash to pay all your liabilities, any remaining cash is equity.
Current assets include cash and assets that will be converted into cash within 12 months. On the other hand, current liabilities are bills that must be paid within 12 months, including accounts payable, short-term debt, and the current portion of long-term debt.
Reviewing current asset accounts
Most businesses use these current asset accounts to operate:
- Cash and cash equivalents: The total amount of money on hand.
- Accounts receivable: The amount that your customers owe you after buying your goods or services on credit.
- Inventory: Items purchased for resale to customers.
- Prepaid expenses: Expenses you’ve paid in advance, such as six months of insurance premiums.
- Investments: Money market account balances, stocks, and bonds. Some investments may be categorized as long term, but most are short-term assets.
- Notes Receivable: Amounts you are owed that will be paid within 12 months.
Most businesses have fewer current liability accounts. The most common accounts are listed below.
Working with current liability accounts
Current liabilities are amounts owed to third parties that must be paid within 12 months.
- Accounts payable: Utility expenses, subscriptions, and amounts owed to other vendors are posted to accounts payable. Think about the monthly bills that you have to pay.
- Payroll liabilities: The dollar amount of payroll owed on the next pay date is a current liability. The balance is posted to accrued wages payable (or simply wages payable).
- Debt payments: These are amounts due on short-term business loans, such as a line of credit or credit cards. They also include any long-term debt where repayments to a lender must be made within a year.
When a business owes funds to a third party, the amount may be posted to an accrual account. Interest owed on a bank loan, for example, is posted to accrued interest.
There are dozens of ratios and metrics you can use to perform analysis, but working capital should be at the top of your review list.
Why is working capital important?
Working capital is important because it measures a company’s liquidity, which is the ability to generate sufficient current assets to pay current liabilities. If you can’t generate enough current assets, you may need to borrow money to fund your business operations. If your company’s current assets don’t exceed its short-term liabilities, it won’t survive for long.
Good working capital management will keep your business operational and can help you avoid cash flow problems.
Considering operating working capital
Operating working capital includes the current assets and current liabilities that relate to day-to-day operations of the business. These are the accounts used in the formula:
- Current assets: Cash, accounts receivable, inventory
- Current liabilities: Accounts payable and accrued expenses
The sum of the three current asset accounts less the sum of the two current liability accounts yields operating working capital.
Operating Working Capital = (Cash + Accounts Receivable + Inventory) − (Accounts Payable + Accrued Expenses)
Operating working capital strips down the formula to the most important components. Prepaid expenses and notes receivable are two current asset accounts that are excluded from the calculation. These two account balances don’t relate to daily business operations and are used less frequently.
Time is just as important as dollars, and businesses that can convert a sale into cash faster than the competition are better off financially. The working capital cycle is a measure of time.
Measuring the working capital cycle
The working capital cycle measures the number of days required to convert net working capital into cash. Here is the working capital cycle for a manufacturer and a retailer:
The manufacturer—a furniture builder in this case—purchases raw materials, builds furniture, sells finished goods to customers, and collects payment in cash. The working capital cycle requires 45 days.
The retailer buys inventory, sells goods to customers, and collects payment in cash. The working capital cycle is completed in 30 days.
The number of days in the cycle depends on the industry and the complexity of the business. For example, an airplane manufacturer will have a longer cycle than a greeting card retailer because building a plane can take a year or longer.
Both online sales and items sold in a physical store must be converted into cash after the sale. A business with a shorter working capital cycle can operate using less cash than other businesses. If you can collect money faster, you can purchase inventory sooner and fund other needs.
7 working capital management tips
Working capital management is an accounting strategy that helps businesses maintain a healthy balance between current assets and liabilities. There are a few working capital management tactics that you can use to improve your working capital, increase efficiencies, and ultimately improve earnings.
Here are a few ways to manage working capital:
1. Create a cash flow roll-forward
Find out where you stand now. Forecast your cash inflows from sales and your required cash outflows by month. Each month’s beginning cash balance plus cash inflows, less cash outflows equals your ending cash balance. If your plan for the next six months reveals negative cash balances, you’ll need to collect cash faster. Once you know the extent of the problem, you can take action.
2. Monitor accounts receivable
Generate an accounts receivable aging schedule each month. The report lists the dollar amounts you’re owed based on the date of the invoice. Aging reports typically group invoices based on 0 to 30 days old, 31 to 60 days old, etc. Older invoices present a higher risk of not being paid.
3. Enforce a collections policy
You should have a written policy for collecting money, and the policy must be enforced to increase cash inflows. Decide on payment terms that encourage early payments. You might email a client once an invoice is 30 days old and call on invoices once they reach 60 days old. If a customer pays late on every sale, consider whether you should do business with the client. Consistent late payments impact your cash inflows.
4. Manage inventory purchases
If inventory is a large component of your cash outflows, monitor your purchases closely. Buy enough inventory to fill customer orders but not so much that you deplete your bank account.
5. Offer discounts
Offer customers a discount (1% to 2%) if they pay within five days of receiving the invoice. You’ll collect money faster, which may be more valuable than the 1% to 2% you lose when the customer takes the discount.
6. Accept electronic payments and credit/debit cards
Make is easy for customers to pay you by offering electronic payment methods on your website. Accept credit and debit cards, and email customers an invoice with a link to make payments.
7. Pay vendors on time
Small business owners can maintain good relationships with vendors by paying them on time. If you’re able to speed up your cash inflows, you can make timely payments and maintain a sufficient cash balance.
If you implement these changes, you’ll convert current assets into cash much faster. Increasing working capital requires a focus on current assets, which are easier to change than current liabilities.
How to use working capital ratios
Here are four key ratios you can use to monitor your working capital balance. Each ratio can be easily generated using accounting software.
The current ratio;
The current ratio uses the same information as the working capital formula. The ratio is current assets divided by current liabilities, and every business needs to maintain a ratio of at least 1.0.
A business with $120,000 in current assets with current liabilities totaling $100,000 has a current ratio of 1.2. The owner has $1.20 in current assets for every $1 of current liabilities.
The quick ratio
The quick ratio (or acid test ratio) adjusts the current ratio formula by subtracting some current assets that take longer to convert into cash. There are several versions of the formula, but the most common subtracts inventory and prepaid assets from current assets. The remaining balance is divided by current liabilities.
Using the same example as above, assume that the business has $10,000 in inventory and no prepaid asset balance. The adjusted current asset total is $120,000 less $10,000, or $110,000. The quick ratio is $110,000 divided by $100,000, or 1.1.
Accounts receivable turnover ratio: collecting cash faster
The accounts receivable turnover ratio is net annual credit sales divided by average accounts receivable. Here are the components of the formula:
- Credit sales: Sales to customers who don’t pay immediately.
- Net credit sales: Credit sales less uncollectible accounts receivable balances.
- Average accounts receivable: The beginning balance plus ending balance for a month, divided by two.
A business should strive to increase credit sales while also minimizing accounts receivable. If you can increase the ratio, you’re converting accounts receivable balances into cash faster.
Inventory turnover ratio: managing inventory levels
The inventory turnover ratio is computed as the cost of goods sold divided by average inventory. If you can increase sales and minimize inventory levels, the ratio will increase. Increasing the ratio means that you are making more sales without having to increase the inventory balance at the same rate.
Put each of these ratios on a financial dashboard so that the information is right in front of you each month. These ratios are the best tools for assessing your progress and increasing working capital.
Take action and improve your results
It’s easy to feel overwhelmed by the amount of financial information you can access about your business. But stay focused on the metrics that are most important, including working capital. Analyze the ratios discussed above and make changes to improve your business results.