As a business owner, it’s easy to feel a little overwhelmed by the sheer number of phrases and terms you need to know about! From tax to business structure and all the way through your finances, it’s important to stay abreast of important terminology and what it means for the success and growth of your company.
Today we’re talking about one such phrase: working capital. Every business has some amount of capital, and it’s a cornerstone of your finances and an important concept to understand. In this article, we’ll cover what the phrase itself means and how you can use the working capital formula to calculate your own working capital ratio.
Starting simple: What working capital is
In basic terms, working capital refers to the amount of money your business can quickly access to help it meet its regular financial obligations. Examples of financial obligations include standard overheads such as rent for property and salary payments for your staff.
A useful way to conceptualise working capital is that it specifically refers to more immediately available money that is used to meet the kinds of expenses that keep your business ticking over. This is different from things like property or more static, long-term investments, which are usually referred to as assets.
So, we understand in fundamental terms what working capital is. Now, let’s look at the next step toward being able to calculate it for your own business. In order to do this, we need to understand another financial concept: current liabilities.
As the name implies, this simply refers to things like bills or debts your business may have that are outstanding. Common examples of current liabilities include business loans, wages for staff, property rent, and accounts payable expenses such as payments due for suppliers.
If you want to calculate your working capital, which we’ll cover in the next section, you’ll need to be able to tally up and put a number on your current liabilities at any given time.
Calculating working capital: The formula
Now that we can calculate current liabilities, we can move on to the formula for calculating working capital. This is done through a formula that gives us a ratio, referred to as the working capital ratio. The formula works as follows: Working capital ratio = Current assets / Current liabilities.
Let’s keep things simple and look at a scenario where we have £400,000 in current assets and £200,00 in current liabilities. This would result in us having a working capital ratio of 2. As you can see, this formula is quick, simple, and effective in its ability to appraise the state of a company’s finances and cash availability.
Why this formula is so important
This most basic form of the working capital formula is important for predicting the current state of a business and its future liquidity or cash-related issues. For instance, a company that has a ratio of lower than 1 may find itself with liquidity issues in the future – or cash flow problems in the short term.
Conversely, if a business has a particularly high ratio – such as over 2 – then it can indicate that the company is holding on to too much cash, and may benefit from reinvesting that money into growing and expanding.
Ultimately, the working capital formula is important for businesses because it helps in understanding and appraising cash-flow related issues. Knowing this can help any company manage risk and understand where they may be vulnerable. While basic in and of itself, this formula is a useful tool to quickly spot issues and help keep your organisation on track.