Working capital is the result of a business’s measurable assets that are available for its day-to-day-operation. It is often a good indication of how a company is being managed as the amount of capital that is available provides a glimpse into the financial health of the business.
It's extremely important for business owners to be able to define working capital so that they can properly measure the impact their efforts are having on their business. Since a company's current capital is a suggestion of how their liabilities are matching up to their assets, most owners want to be able to physically see how well or poorly their business assets are trending.
Working capital is often defined as the difference between a company's current assets and liabilities. It's a common measure of a business's cash flow, productivity, and overall financial health. If the business has sufficient capital, it's a signal that the business is financially healthy and being properly managed. If there isn't enough capital, however, it's a sign that there are operational deficiencies that need to be addressed.
Subtracting a company's current liabilities from its current assets will return the business's current capital.
Current Assets – Current Liabilities = Working Capital
If the result is a positive number, it means the business has sufficient funds. A negative number equates negative working capital meaning the business is in need of more money. While the result of the formula is a good place to start measuring the status of current capital, business owners shouldn't stop there. Having positive capital may appear to be a great sign of financial health, but it's not necessarily a sure sign that the business is being properly managed. To ensure that the business's overall health is well-balanced, owners should take a look at the working capital ratio. This ratio can be determined by dividing the current assets by the current liabilities.
Current Assets / Current Liabilities = Working Capital Ratio
If the result returns a number that is less than 1, this will confirm that the business has negative working capital. If the result is more than 2, this will be a sign of excess and suggests that management isn't investing enough assets or is holding onto too much inventory. If the ratio is between 1.2-2.0, then the result demonstrates that there is sufficient capital, or net working capital.
Net working capital is defined as the company's ability to cover its current liabilities with its current assets. This measurement demonstrates that management has properly allocated the business's assets and is able to maintain short-term liquidity. This measurement is extremely important to creditors, vendors, and investors.
The goal for management should be aimed at maintaining their net working capital. In order to achieve this, they must keep an eye on current assets, such as inventory, accounts receivable, cash and cash equivalents, as well as current liabilities, such as accounts payable and accrued expenses. The easiest way for business owners to manage their current capital is by tracking it on a balance sheet. Once they have their total current assets and liabilities added up, they can subtract the two totals to get the current capital and divide the totals to come up with the ratio. Tracking this ratio period over period or quarter over quarter will provide a clear picture of the business's financial health. If the ratio is trending down, indicating consistent negative working capital, it may be time to consider working capital loans. These small business loans are meant to replenish financial gaps and are deemed to be short term loans. Part of working capital management is being able to discern when it's time to seek monetary help in order to keep the business's finances on track.