What Is Working Capital and How to Calculate It

How's your net working capital or cash flow?

Do you have enough cash? What's your short-term liquidity like? How are the company's current assets looking? We'll help you answer these questions and more. The working capital formula (or working capital ratio) is made of liquid funds/assets that can be used for daily operations. It is the difference between the current ratio of current assets and current liabilities and a measure of a company’s liquidity or cash equivalents.

However, one of the main things that can reduce a company's working capital cash flow is their net terms invoices. That means all the invoices that you're waiting for your customers to pay. If you're a manufacturer, distributor, or wholesaler - chances are you simply have to offer 30, 60, or even 90-day net terms or payment terms to your business customers. Find out how products like Resolve Pay can unlock cash flow and reduce this net terms invoice risk.

Once you know your cash flow, check out Resolve's Cash Flow Calculator. Input your monthly AR and known cash flow to see how much Resolve would improve your cash flow.

The 2 key components of working capital

What current portion of assets are contributing to cash flow? Current assets and current liabilities are the two components of working capital. In this section, you’ll get to know what each is, then we’ll see how they come together to create working capital. This underpins the net working capital formula.

Current assets

Current assets are also consumed, sold, used, or exhausted within one year as part of daily operations. They don't include long-term assets. Being an asset, current assets appear on the balance sheet and contribute to your financial ratios. They consist of:

  • Cash
  • Inventory
  • Accounts receivable
  • Real Estate
  • Prepaid liabilities
  • Stocks and bonds & marketable securities

Current assets can quickly be turned to cash and are sometimes referred to as liquid assets.

Current liabilities

This will help you determine the company's short-term financial health. If you're a small business this is something you want to keep an eye on. Business owners need to know their company's ability to survive a dip in sales. Current liabilities include debt obligations and are also on the balance sheet. They are financial obligations that are due within one year. Current liabilities include:

  • Short-term debt
  • Wages
  • Taxes
  • Rent
  • Utilities
  • Supplier invoices
  • Notes payable

Current liabilities are paid with current assets.

How to calculate working capital & cash flow

Let's get to the excel sheet! The following formula is used to calculate working capital:

Net working capital = current assets - current liabilities

As you can see, it is simply the difference between current assets and liabilities. Since working capital is dependent on current assets and liabilities, this also means it is “current.” In other words, working capital is always dealing with a short-term time frame.

Working capital is immediate cash to meet the immediate obligations of day to day operations. Immediate obligations never go away and must be handled daily. This is why cash flow is called the lifeblood of a business. You can't depend on fixed assets. Without cash flow, a business will quickly seize up and cease to exist. Working capital is dependent on cash flow. It’s cash flow that fills the coffers of working capital.

How does Resolve help with cash flow?

Chances are you are producing finished goods from raw materials and selling them to other businesses. How are net terms invoices, and late payments impacting your cash flow? Do you offer your customers a line of credit? Let me tell you about Resolve Pay...

Resolve means your customers get net terms, you get paid faster. We're a complete B2B credit management and net terms solution. If you’re looking for a better way to manage the nightmare of customer credit checks, net terms risk, payments, and cash flow woes - Resolve is here to help. We believe your business shouldn’t act like a bank unless you’re actually a bank. Get paid by Resolve in a day, and we’ll let your customers pay us in 30, 60, or 90 days. However your customers buy from you, e-commerce or offline, we've got you covered.

If you're currently offering net terms to your customers check out this page on how we can help manage your existing net terms. If you're brand new to net terms, but cash flow was stopping you from exploring this avenue to boost your b2b sales, check out our new to net terms page. Don't risk floating long-term debt for your customers, let Resolve take on the risk of floating net terms.

What is net working capital? (and how it affects business operations)

Turns out businesses need free cash flow, and you don't want to depend on short-term loans. Any business that wants to grow and build out a network of suppliers needs working capital. It allows a business to pay for short-term expenses. It is also used by suppliers to evaluate the financial health of a business. Suppliers want to ensure that they are dealing with a reliable business and that they’ll get paid on time. Analyzing a potential customer’s working capital provides the necessary insights into the efficiency of a business. Of course, further analysis is needed to determine overall creditworthiness. Let's get into the working capital calculations.

Credit

This doesn't mean credit cards. Companies with net positive working capital can more easily obtain credit than those with negative working capital. Some suppliers will go further than determining if a business has only positive working capital. The amount of working capital is also factored into how much credit a company will receive. This is generally determined using an average working capital that is based on industry and company size.

Suppliers

It’s also easier to find suppliers when a company has net positive working capital. In contrast, net negative working capital is a sign of a less stable business and one that suppliers will be more reluctant to work with. Overall, positive working capital can help a business grow, whereas negative working capital can constrain it.

Cash-on-hand

More working capital means more cash-on-hand to expand into new ventures. While working capital is mostly used for short-term needs, as a company grows and is able to consistently build up its working capital, more money is available to help with its expansionary needs. Working capital that goes beyond what is required for short-term obligations can be used to help grow the company. In some cases, when a company has enough working capital, it can forego loans in place of its available cash.

Working capital shouldn’t be confused with cash. Cash is a component of working capital and there is no minimum or maximum cash percentage. Some companies may have a lot of working capital but very little cash. This would mean they have more short-term non-cash assets. If the company needs cash, it would have to convert these assets into cash, which shouldn’t be a problem since they are liquid assets.

Why companies need to track their working capital & cash flow

Working capital is both a performance metric and a key indicator. The efficiency of a business can be tracked by changes in the trend of its working capital. Increasing working capital may be a sign of dropping expenses or increased cash flow. Decreasing working capital can mean short-term liabilities are overtaking short-term assets. As well, since working capital is necessary for a business to operate, it’s always important to understand what this indicator is saying.

Determine cash flow

Cash flow is a critical part of a business's financial health, and tracking working capital helps you understand cash flow. As mentioned earlier, cash flow is the lifeblood of any business and the source of working capital. Understanding the trend of cash flow will help determine future working capital. Now you've calculated cash flow, why not improve it? Check out Resolve's Cash Flow Calculator impact estimator.

Gauge overall efficiency & profitability

Working capital is a decent general measure of business efficiency and profitability. A business that isn't producing cash flow can still have working capital. However, it will be diminishing every month. Diminishing or deficient working capital signifies that cash flows are absent or current liabilities are eating up all working capital. Both are adverse scenarios.

Understanding the trend in working capital provides feedback about how efficiently a business is performing. A quick drop in working capital might be explained by money shifting to expansion projects, which is a net positive for the business. If the drop were due to an increase in debt services, that would indicate the business is running poorly — working capital is being rapidly depleted for non-productive use (i.e., loan payments).

A company that is able to sustain a consistent level of working capital shows that it has good cash flow and is in control of its expenses. There’s money remaining for expansion as well. As with many business performance metrics, following the trend over a period of time can help to reveal potential trouble or that the business is improving.

Conduct risk analysis

Higher working capital typically means less risk. This is because working capital can act as a cushion against unforeseen expenses. This scenario is especially helpful for companies that don't have access to credit. For those companies, building up above-average working capital will help to offset financial shocks.

Expand into new markets or develop new products

If you want to expand your business, you’ll likely need working capital or access to credit. This is similar to buying a home. Most people who want to buy a home can only afford a down payment. The balance is provided by a loan (i.e., mortgage). Similarly, businesses that want to expand need access to far more funds than they have available.

While a company’s working capital may not be enough to pay for expansion, it can help the company to get a loan. Lenders will evaluate a company’s working capital as a main lending decision factor. The better maintained a company’s working capital is, the more likely the company is to get approved for a loan and the more loan it is likely to get.

Conclusion

Everyone needs healthy cash flow. Instead of calculating it - why not look at the root causes that are tying up your cash flow? Chances are you're floating net terms invoices and waiting for 30, 60 or even 90 days to get paid. Resolve Pay will unlock your cash flow and transform the financial health of your business. Find out how.

Working capital is essential to the efficient operation of any business. Without working capital, a business isn’t able to pay for its short-term financial obligations, gain access to credit, or get approved for loans. No working capital can be a sign that short-term liabilities are unsustainable. Working capital is fed by cash flow, which means positive cash flow is required to maintain working capital. Working capital is also an important metric in evaluating business performance.

Net terms & credit management

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