The formula used to calculate working capital of any business is
Current Assets – Current Liabilities = Working capital
If we further explain the formula, we will find that working capital is the value remaining after deducting of all short-term liabilities from the liquid assets of the company.
This is an important tool used to evaluate the ability of a business to pay off its current liabilities. This tool is also used by management for financial analysis, financial modeling and managing cash flows of the business.
The working capital formula focuses on the ability of the company to pay back its debt which will be due in the next 12 months, that’s why the company’s creditors and vendors always adjust their business with the company on the basis of these calculations.
Impact of Positive or Negative Working Capital
If the value generated from the formula is positive, it means that there is a sufficient amount of liquid assets available with the company to meet its current liabilities while in case of negative results, it shows that the company may not be able to meet its liabilities due in next 12 months.
This situation will force the company to use its long-term assets or get some extra loan from outside to meet its currents liabilities which is always a bad Indicator for any business.
Important Components of the Formula
The working capital formula is the comparison of the balance sheet current portion i.e. current assets and current liabilities. In most cases, current assets include cash, account receivable, inventory, and short-term investment of the company.
While the current liabilities typically include all short-term trade payables, accrued expenses, short term advances received, and any short-term debt.
Example:
The balance sheet of Blue-end Company is as follows
Assets | Liabilities and Equity | ||
Current assets: | Current liabilities: | ||
Cash and cash equivalents | $ 2,000 | short term debt | $ 1,200 |
Accounts Receivables | $ 2,500 | Accounts Payables | $ 3,000 |
Inventories | $ 3,500 | Accrued Liabilities | $ 2,000 |
Total Current assets | $ 8,000 | Total current liabilities | $ 6,200 |
Non-current assets: | long term liabilities: | ||
Property, Plant and equipment | $ 12,000 | long term debt | $ 5,000 |
Investments | $ 1,500 | Equity: | |
other non-current assets | $ 500 | Preferred Stock | $ 2,000 |
Total Non-current assets | $ 14,000 | Common stock | $ 7000 |
Total Assets | $ 22,000 | Retained earnings | $ 1,800 |
Total Equity | $10,800 | ||
Total Liabilities and Equity | $ 22,000 | ||
Required:
Calculate working Capital
Solution:
Function for Working capital = Current Assets – Current Liabilities
Current Assets=Cash & Cash Equivalents + Account Receivable + Inventories
Current Assets = $2,000+$2,500+$3,500 = $8,000
Current Liabilities = Short Term Debt + Account Payable + Accrued Liabilities
Current Liabilities= $1,200+$3,000+$2,000= $6,200
Put the values in the formula
Working Capital= $8,000 – $6,200 = $1,800
Explanation:
After all the calculation we find that the value of Blue-end current assets is more than their current liabilities which results in positive working capital.
Now we can analyze that there are sufficient funds available with the company to pay their current liabilities.
In other words, we can conclude that Blue-end have a sufficient amount of liquid assets which can be used to grow the business without affecting the current liquidity position of the company.
How company can improve their working capital in positive direction?
Companies can improve their liquidity position in 3 different ways. Like, management can analyze company’s account receivables and make strategies to shorten the period of recovery time of their account receivables, in the second way company may adopt some strategies to keep the inventory position on a very suitable level on the basis of company needs and supply of material, while another way could be that the company may deal with creditors of the company to extend their credit period for a bit longer than the normal period.
These strategies will increase the availability of hard cash in the business which will positively affect the net working capital of the company.