Running an efficient and sustainable business means being on top of your day-to-day finances. It also means understanding your available working capital. This includes the liquidity, efficiency, and short-term financial health of your company. But as a business owner, knowing how to find working capital is important, especially if you need to grow your business.
But first, what is your company’s working capital ratio and how do you calculate it?
What Is Working Capital?
Working capital, also known as net working capital, is the ratio of your current assets to your current liabilities. The resulting quotient is generally used to determine the capability of your business to meet its short-term financial commitments.
There are a lot of factors included in the two components of the working capital. Your current assets include the following:
- All belongings, tangible and intangible
- Bank accounts
- Accounts receivable
These resources can be quickly converted to cash within a year or business cycle. This means that long-term investments like real estate or hedge funds are excluded.
Current liabilities, on the other hand, include all expected expenses within the year or the business cycle. This is the time that typical expenses come in. These expenses include the following:
- Accounts payable
- Accrued income taxes
Included in the calculation are long-term debts and capital leases. Typically, these debts and leases are due within the year.
How to Compute for Working Capital
Computing the working capital is pretty straightforward, as the formula is simple:
Current Ratio = Current Assets Current Liabilities
Getting a ratio above one (1) generally means that your assets exceed your liabilities. If you’re planning on expanding your business, you’ll want to aim for a ratio higher than 1.
Let’s illustrate this formula with an example. A global company has a total of $37 billion in current assets for the fiscal year ending December 31, 2018. These include cash and cash equivalents, inventories, short-term investments, and accounts receivable. During the same period, this company has accrued $26 billion in current liabilities. These include accounts payable, accrued expenses, accrued income taxes, and maturing long-term debt.
Using the formula above, the company has a current ratio of 1.42 in working capital. This means that this company has the means to fund their day-to-day operations. They can also pay off their debt commitments.
Why You should Aim for a Working Capital Ratio Higher Than 1
As mentioned earlier, you’ll want to aim for a ratio higher than 1 if you want to continue with your business. Having a ratio lower than 1 puts your business at risk among creditors and investors. They consider having a low ratio or a negative working capital to mean that your business may not be capable of paying and covering all current debt.
Keeping your working capital above 1 means you understand how some current assets and liabilities can change. These changes can occur within a 12-month period. For example, working capital like accounts receivable or inventory may lose its value. Long-term liabilities may soon become a current liability. This may happen when the deadline for repayment is just around the corner. Some accounts receivable might even be written off at some point. This would definitely result in another loss.
Why Having a Working Capital Ratio Above 2 Isn’t Good Either
Having too high of a working capital is not a good thing, either. Generally speaking, anything higher than two (2) may put off investors and creditors as well. It shows that your business is letting any excess assets sit idle and unmoving. If your working capital is on the brink of breaching the ratio of 2, it’s the best time to consider expanding your business. This could come in the form of a new location or a new product or service offering.
What to Do with a Negative Working Capital Ratio
What if your business is working with a negative working capital? Is there a way to turn things around? This is the time where you’ll need to put in place a couple of changes, particularly in how you’re spending money for your business.
For one, you can always reduce your daily expenses by looking for more affordable equipment or negotiating with other sellers. If the trouble lies with your accounts receivable, try incentivizing timely payments from your customers. You can even look for current tax opportunities in your state to ensure that your business is in the best position.
How To Find Working Capital
You can work with Lending Builder to help you find working capital loans for your business. Get help from funding experts who offer unbiased reviews for working capital loans for small business owners. If you need help growing your business and are looking for working capital loans, you can take our Working Capital quiz here. After which, we’ll get in touch with you with our recommendations.