Learn about Working Capital Calculation Formula and Ratio

Working capital formula

To calculate working capital requirements, you can use the formula mentioned below:
Working capital (WC) = current assets (CA) – current liabilities (CL).
If the value of total current assets is Rs. 3,00,000 and current liabilities is Rs. 1,50,000, your company’s working capital will be 3,00,000 - 1,50,000, which equals to Rs. 1,50,000.

Current assets

Current assets are resources that a company expects to convert into cash or use up within the next 12 months. They represent economic benefits that the company has a right to claim. In calculating working capital, one assumes the liquidation of these items into cash.

Cash and cash equivalents: Includes all available cash, foreign investments, and low-risk, short-term assets like money market accounts.
Inventory: Consists of unsold goods such as raw materials, work-in-progress, and finished products awaiting sale.
Accounts receivable: Represents amounts owed to the company for sales made on credit, adjusted for any potential doubtful debts.
Notes receivable: Includes claims for cash from formal agreements, typically documented by signed contracts.
Prepaid expenses: Expenses paid in advance that provide value in the short term, even though they are not easily converted to cash.
Others: Short-term assets that do not fit into the above categories, such as deferred tax assets that offset future liabilities.

Current liabilities

Current liabilities are the debts a company is required to settle within the next 12 months. Evaluating working capital involves determining whether the company can cover these liabilities with its available short-term assets.

Accounts payable: Includes unpaid bills for supplies, raw materials, utilities, property taxes, rent, or other operating expenses. Typically, these invoices have net 30-day terms.
Wages payable: Represents unpaid salaries and wages for employees, usually accruing up to one month’s worth of wages depending on payroll cycles.
Current portion of long-term debt: Consists of the short-term portion of long-term debt that is due within the next year.
Accrued tax payable: Taxes owed to government entities that are accrued but not yet due, with payment expected within the coming year.
Dividend payable: Amounts authorized for payment to shareholders. While future dividends might be adjusted, obligations for declared dividends must be met.
Unearned revenue: Funds received before work is completed. If the company fails to perform the contracted services, it may need to refund this advance payment.

Here is an illustration to help you understand working capital calculation:

Say that your business hasthe following current assets:

Goods sold on credit: Rs. 2,00,000
Raw materials: Rs. 2,00,000
Cash in hand: Rs. 1,50,000
Obsolete inventory: Rs. 40,000
Loans given to employees: Rs. 50,000

The total value of the current asset would thus be a sum of the values given above except for cash in hand, i.e., Rs. 4,90,000. Available cash is the ultimate measure of liquidity and frequently changes with either receipt or payment. Adding it to the current assets does not accurately portray a business's liquidity.

Say that your current liabilities include:

Outstanding funds payable to creditors: Rs. 1,70,000
Unpaid expenses: Rs. 80,000

The total value of current liabilities thus stands at Rs. 2,50,000 (A sum of the above two values).
Using the working capital formula, you can estimate the business's liquidity status.

Working capital ratio formula

The working capital ratio, also known as the current ratio, is a vital financial metric used to assess a company's short-term liquidity position and its ability to cover immediate financial obligations. It is calculated by dividing a company's current assets by its current liabilities. The formula for the working capital ratio is:

Working Capital Ratio = Current Assets/Current Liabilities

For example, if a company has current assets worth INR 500,000 and current liabilities amounting to INR 300,000, the working capital ratio would be:

Working Capital Ratio = 500,000/300,000 = 1.67

This implies that the company has INR 1.67 in current assets for every INR 1 in current liabilities, indicating a healthy liquidity position. A ratio above 1 suggests that the company has sufficient short-term assets to cover its short-term liabilities.

What is the working capital requirement?

The working capital requirement represents the amount of capital a company needs to maintain its day-to-day operations and meet short-term financial obligations. It is determined by subtracting current liabilities from current assets. Current assets include cash, accounts receivable, and inventory, while current liabilities consist of accounts payable and short-term debt. Understanding the working capital requirement is crucial for ensuring sufficient liquidity to cover operational expenses, manage inventory levels, and fulfil financial commitments promptly. By accurately assessing and managing the working capital requirement, businesses can optimize cash flow, mitigate liquidity risks, and sustain operational efficiency.

The working capital cycle formula is:

Inventory Days + Receivable Days - Payable Days = Working Capital Cycle in Days

What is the purpose or importance of working capital in a business?

Working capital is the lifeblood of any business as it is the amount of funds required to run day-to-day business operations. It refers to a company's current assets (cash, inventory, account receivables, etc.) minus its current liabilities (account payables, short-term loans, etc.). The importance of working capital lies in its ability to help businesses manage their cash flow pay suppliers, resume operations during economic downturns, and finance operational expenses. A healthy working capital position ensures that businesses have enough funds to cover their short-term expenses, manage payment obligations, and take advantage of growth opportunities.

Positive vs negative working capital

Positive working capital is essential for a successful business operation, as it enables companies to cover their short-term obligations and invest in future growth opportunities. When a company has more short-term assets than liabilities, it has positive working capital.

Meanwhile, negative working capital can create cash flow problems, making it challenging for the business to pay bills and creditors on time. It may also negatively affect the company's credit rating and limit access to future financing.

Abusiness owner can improve their company’s positive working capital by taking out a working capitalloan. It can boost liquidity and provide the necessary funds to cover short-term obligations.

Adjustments to the working capital formula

Businesses can adjust the working capital formula to improve the accuracy of their assessment. These adjustments include:

Factoring in cash reserves to current assets.
Excluding inventory from the working capital calculation in the case of financing options.
Excluding non-operating assets such as long-term securities and investments.
Seasonal adjustments to account for inventory and accounts receivable fluctuations.
Considering debt maturity for better working capital requirement calculation.

By adjusting the working capital formula, businesses can better determine their financial position and calculate working capital requirements accurately.

What is a good working capital ratio?

A good working capital ratio is generally between 1.2 and 2. A ratio above 2 may indicate that a business has too much inventory or is not investing in growth opportunities. Conversely, a ratio below 1.2 may indicate that a business has too little liquidity to meet its short-term obligations. However, a "good" working capital ratio can vary depending on the industry, business size, and other factors. Therefore, it is important to factor in these considerations and use other financial ratios to assess a business’s financial health and working capital needs.

Importance of using the working capital formula

Working capital formulas are essential for businesses to assess their current financial position and understand their working capital requirements. By using these formulas, businesses can:

Monitor and manage cash flow effectively.
Identify areas where they need to improve their financial efficiency.
Reduce the need for external financing such as working capital loans.

Overall, the use of working capital formulas enables businesses to make better-informed decisions and optimise their financial performance, leading to greater stability and success in the long term.

List of working capital formulas

Here’s a list of key working capital formulas used to assess a company's financial health and liquidity:

1. Working capital

Formula: Working Capital = Current Assets - Current Liabilities
Description: Measures the difference between a company’s current assets and current liabilities to determine its short-term financial health.

2. Current ratio

Formula: Current Ratio = Current Assets / Current Liabilities
Description: Assesses a company’s ability to pay short-term obligations with its short-term assets. A ratio above 1 indicates more assets than liabilities.

3. Quick ratio (acid-test ratio)

Formula: Quick Ratio = (Current Assets - Inventory) / Current Liabilities
Description: Evaluates a company's ability to meet short-term liabilities without relying on the sale of inventory.

4. Cash conversion cycle

Formula: Cash Conversion Cycle = Days Sales Outstanding + Days Inventory Outstanding - Days Payable Outstanding
Description: Measures the time taken to convert working capital into cash flow from operations.

5. Days Sales Outstanding (DSO)

Formula: DSO = (Accounts Receivable / Total Credit Sales) x Number of Days
Description: Indicates the average number of days it takes to collect payment after a sale.

6. Days Inventory Outstanding (DIO)

Formula: DIO = (Inventory / Cost of Goods Sold) x Number of Days
Description: Measures the average number of days inventory is held before being sold.

7. Days Payable Outstanding (DPO)

Formula: DPO = (Accounts Payable / Cost of Goods Sold) x Number of Days
Description: Represents the average number of days a company takes to pay its suppliers.

8. Net Working Capital Ratio

Formula: Net Working Capital Ratio = Net Working Capital / Total Assets
Description: Measures the proportion of a company's assets that are financed by working capital.

These formulas help in analysing and managing a company's working capital to ensure smooth operational efficiency and financial stability.

Learn about Working Capital Calculation Formula and Ratio | Bajaj Finance (2024)