Even a business with growing revenue and projected profits can go bankrupt if it doesn't have sufficient cash on hand. After all, accounting profits on your books at the end of the year can’t be used to pay your bills today. That’s why it's key that your business maintains adequate working capital to cover expenses.
What is working capital?
Working capital, also known as net working capital, is the money that your business has on hand to pay short-term expenses and liabilities. Working capital is composed of current assets that will be available for use within the next 12 months. Current assets can include:
- Accounts receivable
- Marketable securities
- Other liquid assets
Businesses use working capital to cover current liabilities , or those debts and expenses that a company is responsible for over the next 12 months. Current liabilities can include:
- Accounts payable
- Loan interest payments
- Debt payments
- Tax obligations
How to calculate working capital?
To calculate your working capital, subtract current liabilities from current assets. These values are found on your company’s balance sheet.
Let’s look at an example. Say a small fitness equipment manufacturer has current assets of $150,000. They have current liabilities of $125,000.
$150,000 - $125,00 = $25,000
The company has a working capital of $25,000. This means they are in the green and can expect to have the funds to cover expenses.
If a company has negative or insufficient working capital, it is at risk of missing payments to vendors, being unable to pay employees, defaulting on debts, and going bankrupt.
What is working capital ratio?
In addition to tracking current liabilities against current assets, you should also aim for a target working capital ratio, or current ratio. The working capital ratio is a measure of a company’s liquidity and an indicator of short-term financial health. A ratio between 1.2 and 2 is ideal. A ratio below one means the company may not have enough liquid assets to cover short-term liabilities.
Let’s stick with our fitness equipment manufacturer from above for an example. Remember, the company has current assets of $150,000 and current liabilities of $125,000.
Working Capital Ratio → 150,000/ 125,000 = 1.2
The manufacturer has a working capital ratio of 1.2 and should be able to cover its short-term financial obligations.
While a ratio below 1 forecasts liquidity troubles, an excessively high working capital ratio is not ideal either. A ratio above 2 suggests that a company is making poor use of its resources and is not getting the best return on assets. This could be due to inventory surplus, failure to pay off debts, or excess cash that is not reinvested into the business.
Why does working capital matter?
If a business’s working capital is insufficient to service short-term debt and operating expenses, it quite literally may not be able to keep the lights on. Insolvency and bankruptcy could follow. To avoid this, the business may need to sell off valuable assets, lay off workers, or raise more capital through loans or bonds.
But all of these actions jeopardize the future viability of the company.
Selling assets can hinder output and decrease the total value of your company. Laying off workers places a strain on remaining employees. It also creates immediate and future HR headaches and expenses. Taking out loans or offering bonds solves a short-term problem in exchange for a long-term one. Eventually, you’ll have to pay these back with interest, making future working capital management more difficult.
A far better option is to plan for your capital needs by understanding market fluctuations, anticipating demand, and maintaining a cash cushion.
There's no reason to wing it
Knowing your current and future capital needs informs your business decisions and helps to ensure you are on track to meet financial obligations and business goals.
With an awareness of your capital needs, you can invest in transformational technology or pivot to a new sales channel when external conditions change. Or, should you face a short-term capital crunch, you can make an informed decision about whether or not to borrow funds to pay expenses.
When it comes to capital needs, there is no reason to wing it.
Calculate your business’s working capital with our working capital worksheet.