The company’s working capital is important for the number of key stakeholders including executives, employees, and shareholders, and investors. Positive working capital simply means the company’s current assets at the reporting are higher than its current liabilities.
That means, in the short-term, around 12 months from the reporting date, the company could use the current assets that it has to pay off its current liabilities.
In other words, if the company use has negative working capital, the company is said to have a working capital problem considering the total current liabilities that it has at the reporting date are higher than the current assets that it has.
For example, the total account payable that they need to pay within the 12 months, are higher than the total receivable and cash that it has.
In this article, you will learn on how to calculate the working capital and how to interpret them to your stakeholders.
Formula:
Current Assets – Current Liabilities = Working capital
If we further explain the formula, we will find that working capital is the value remaining after deducting all short-term liabilities (Current liabilities) from the liquid assets (Current 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 the 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.
What Are the Current Liabilities and Where to Find Them?
As you can see the extracted of the current liabilities from the financial statements below, current liabilities, not limited to this example, including Accrued, short-term loan, short-term lease, account payable, salaries or wages payable, income taxes payable, and others.
| Current liabilities: | US$ |
| short term debt | $1,200 |
| Accounts Payables | $3,000 |
| Accrued Liabilities | $2,000 |
These current liabilities are reported in the company’s financial statements, balance sheet specifically at the end of the reporting date. In the balance sheet, they are reported separately from the non-current liabilities. They are reported only in the balance sheet and are not reported in other statements.
What Are the Current Assets and Where to Find Them?
| Current assets: | US$ |
| Cash and cash equivalents | $2,000 |
| Accounts Receivables | $2,500 |
| Inventories | $3,500 |
| Total Current assets | $8,000 |
As per the table above, the current assets including cash and cash equivalents, account receivable, note receivable, inventories, advance, and other current assets.
In the calculation of working capital, inventories are also including with other current assets even though they might not convert into cash as quickly as other assets like cash and receivables.
Impact of Positive or Negative Working Capital
If the value generated from the formula is positive, it means that there is a sufficient amount of liquid assets available with the company to meet its current liabilities while in case of negative results, it shows that the company may not be able to meet its liabilities due in next 12 months.
This situation will force the company to use its long-term assets or get some extra loan from outside to meet its currents liabilities which is always a bad Indicator for any business.
Important Components of the Formula
The working capital formula is the comparison of the balance sheet current portion i.e. current assets and current liabilities. In most cases, current assets include cash, account receivable, inventory, and short-term investment of the company.
While the current liabilities typically include all short-term trade payables, accrued expenses, short-term advances received, and any short-term debt.
Example:
The balance sheet of Blue-end Company is as follows
| Assets | US$ |
| Current assets | |
| Cash and cash equivalents | $2,000 |
| Accounts Receivables | $2,500 |
| Inventories | $3,500 |
| Total Current assets | $8,000 |
| Non-current assets | |
| Property, Plant, and equipment | $12,000 |
| Investments | $1,500 |
| other non-current assets | $500 |
| Total Non-current assets | $14,000 |
| Total Assets | $22,000 |
| Liabilities and Equity | |
| Current liabilities | |
| short term debt | $1,200 |
| Accounts Payables | $3,000 |
| Accrued Liabilities | $2,000 |
| Total current liabilities | $6,200 |
| long term liabilities | |
| long term debt | $5,000 |
| Equity | |
| Preferred Stock | $2,000 |
| Common stock | $7,000 |
| Retained earnings | $1,800 |
| Total Equity | $10,800 |
| Total Liabilities and Equity | $22,000 |
Based on the balance of the Blue-end Company above, working capital of the company is calculated as below:
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 calculations 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 a company can improve its working capital in a positive direction?
Companies can improve their liquidity position in 3 different ways. Like, management can analyze a company’s account receivables and make strategies to shorten the period of recovery time of their account receivables.
In a second way, the 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.
Another way, 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.