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What is Working Capital Formula and Ratio

Every business owner faces challenges daily, but few are as pressing or as stressful as maintaining a financially healthy company. To remain solvent and continue the push for greater successes, every company must have a clear understanding of its working capital and liquidity, or you may run out of cash and lose the ability to pay the bills or meet other necessary obligations.

Understanding working capital's effect on operational abilities is a fundamental step for any business owner. What is working capital, though, and how can you manage it effectively?

Working Capital Defined

Working Capital Management is an essential function for any business, but it starts with understanding what you're facing. In short, this is a measure of the financial wiggle room your company has: in other words, the assets it can use to do business daily. The amount of working capital available to a business is a function of subtracting the company's total liabilities from its total assets.

In general, it serves as a useful barometer for a firm's financial footing.

There are three central components to working capital to understand:

  • Accounts Receivable: The core of any company's financial assets, these are payments received or to be collected from the company's customers.
  • Liquid Assets: Cash and cash equivalents that you can convert easily.
  • Inventory: Another component of a company's assets, inventory includes not only finished goods ready for sale but raw materials as well. These are tangible items of value.
  • Accounts Payable: Making up the other side of the equation, accounts payable are financial liabilities, including payments owed to suppliers or tax authorities. Short term debt may also fall under this umbrella.

As important as managing a company's liquidity may be, it's not straightforward with so many moving parts. That's where the cash flow statement comes into focus. Most easily generated by accounting software, this is a simple way to measure your working capital ratio by dividing current assets and current liabilities.

The cash flow statement puts all the data you need in one place, showing a complete summary of the flows in and out of the business without factoring in future revenue. The resulting statement is a clear and immediate snapshot more useful than a glance at the balance sheet.

Working Capital Formula

The Working Capital Formula conveys the short-term liquid assets remaining after short-term liabilities have been paid off. It is a measure of the short-term liquidity of a company. It is an important asset of financial analysis, financial modelling, and managing cash flow.

Working capital = Current Assets – Current Liabilities

In other words, it displays the difference between a company's current assets and current liabilities. The challenge with it is to determine properly the category of the vast majority of assets and liabilities on the balance sheet. Doing this wrong can mean further issues down the down when evaluating a company's financial health. 

To learn more about Working Capital Formula and its calculation, check out this guide by Corporate Finances Institute.

Working Capital Ratio

The Working Capital Ratio is a measure of liquidity of a company. It reveals if a business can pay its obligations. This ratio is the proportion of an entity's current assets to its current liabilities. In other words, it shows the ability of a business to pay for its current liabilities with its current assets in a form of a single number. This number itself is a financial health indicator and can be used for fast reporting to shareholders, company employees or as quick-check for management to predict potential issues.

A working capital ratio of less than 1.0 is a strong indicator of liquidity issues, while a ratio in the proximity of 2.0 represents good short-term liquidity.

To calculate the working capital ratio, divide all current assets by all current liabilities. The formula is:

Current assets ÷ Current liabilities = Working capital ratio

To learn more about Working Capital Ratio, its calculation and examples, check out this read by Accounting Tools

Liquidity Challenges: Navigating Concerns About Current Obligations

Sometimes, the numbers don't tell the story you'd like. Negative working capital threatens your company's ability to meet its obligations and signals an immediate need to take corrective action, such as when large accounts receivable go unpaid by slow clients. Increasing sales or calling due invoices can help to improve short term assets on hand to raise your networking capital back to above the threshold.

Ideally, though, this situation never occurs thanks to careful capital management tactics. Careful cash flow management is the key to avoiding a liquidity crisis by maintaining positive working capital. Using the right tools delivers invaluable insight into when a business needs an immediate cash infusion.

Summary

Understanding working capital and how to manage it appropriately is essential for success in any business, but there are often company-specific challenges to address. Keeping track of all the numbers can often prove tricky.

However, with an easy way to generate the reports one needs, from cash flow statements to more in-depth looks at specific accounts receivable and payable, staying on top of the data can help you to avoid a liquidity crisis.

Equip yourself with the right tools for the job — take advantage of the cash flow management tools built in the ZarMoney when you try the software FREE today.

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