Working Capital Formula: A Comprehensive Overview

Working capital is an important financial metric that helps companies understand their short-term financial health. Business owners, lenders and investors calculate the working capital of companies before investing using the working capital formula. 

Read on to learn how to calculate working capital, the importance of the working capital formula, and a good working capital ratio.

How to Calculate Working Capital Requirements?

Working capital is the difference between a company’s current (short-term) assets and current liabilities. It is also known as net working capital and can be used to measure the company's short-term financial health or liquidity. You can use the following working capital formula to calculate a firm's net working capital:

Working Capital = Current Assets - Current Liabilities

Where,

Current Assets: Short-term assets, i.e., assets that can be easily liquidated to cash.

Current Liabilities: Short-term obligations that are due within a year.

Understand Working Capital Calculation With Example

The given illustration will help you understand how to use the working capital formula.

Let’s assume Company X has the following current assets.

• Raw materials - Rs. 2,00,000
• Loans lent to employees - Rs. 50,000
• Goods sold on credit - Rs. 4,00,000
• Obsolete inventory - Rs. 40,000

Thus, the total current assets for Company X is Rs. 6,90,000

The current liabilities of Company X consist of the following:

• Unpaid expenses - Rs. 80,000
• Outstanding fund payable to creditors - Rs. 1,70,000

This makes the total current liabilities of Company X = Rs. 2,50,000

Now, let’s calculate the working capital using the net working capital formula, which is,

Working Capital = Total assets - Total liabilities

Working Capital = Rs.  (6,90,000 - 2,50,000)= Rs. 4,40,000

Importance of Using the Working Capital Formula

Here’s why the working capital formula is important:

• To know your business's finances well to reduce external financing requirements like loans.
• To manage and monitor the company’s cash flow effectively.
• To have a clear understanding and identify areas that need improvement in financial efficiency.

List of Working Capital Formulas

Here are some commonly used working capital formulas:

1. Working capital = current assets – current liabilities.
2. Net working capital = current assets (minus cash) - current liabilities (minus debt).
3. Operating working capital = current assets – non-operating current assets.
4. Change in working capital = working capital (current year) – working capital (previous year). 
5. Non-cash working capital = (current assets – cash) – current liabilities.

Adjustments to the Working Capital Formula

For a better analysis, businesses can adjust their gross working capital formula to a certain degree. These adjustments can include the following.

• Seasonal adjustments for account receivable fluctuations and inventories.
• Exclusion of inventories from working capital calculations for financing.
• Considering debt maturity for better working capital fluctuation.
• Factoring the cash reserves to current assets.
• Excluding long-term securities and similar non-operating assets.

What is a Good Working Capital Ratio?

The working capital ratio is calculated by dividing a company's current assets by its current liabilities. It measures whether a business is operating with a net positive or negative working capital position.

A working capital ratio between 1.2 and 2 is considered an ideal or good working capital ratio. If your company's working capital ratio is below 1.2, it means it is likely running low on liquidity. Consequently, the company will soon face a tough time while repaying its dues. This can be a red flag for investors and lenders.

However, if the working capital formula states the ratio above 2, it implies the company is highly liquid and has abundant cash to pay future and ongoing debts. It also reflects that the company has enough money to invest in its business expansion plans.

Also Read - What is Working Capital? Its Meaning, Example and Importance

Positive vs Negative Working Capital

Working capital of a company can be categorised into two types: positive working capital and negative working capital. Positive working capital indicates that a company has more short-term assets than liabilities. It helps a company invest in future endeavours and cover its short-term debts.

Negative working capital, on the other hand, can indicate liquidity and cash flow problems. Lenders and investors might not consider companies with negative working capital as good investments. Negative working capital can also lower a firm's credit score.

Also Read - Working Capital Cycle: Definition & Complete Overview

To Conclude

Every large and small business owner must know about the working capital formula to be aware of the company's financial needs. By closely analysing working capital, you can have an idea regarding your business’s liquidity and take steps accordingly. Calculating working capital is also essential for investors as it helps them conduct deep research and analyse a company’s financial performance. This helps them to compare and deduce which company will be worthy of their investment in the long run.

Disclaimer

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