Having many expenses is an inevitable part of owning a small business. But, you also need to be able to generate enough money to pay for those expenses. To determine whether you can pay off your short-term debt, you need to understand working capital.
What is working capital?
Working capital shows you what is left over after you subtract your current liabilities from your current assets. It measures whether your business can meet immediate financial obligations.
Current liabilities are debts you must pay off within 12 months. Liabilities are amounts you owe, like loans or accounts payable.
Current assets are cash or other assets that can easily be converted into cash within 12 months. Assets are valuable items that can be either intangible (e.g., a trademark) or tangible (e.g., a business car).
You can find both current liabilities and current assets on your business’s balance sheet.
You must frequently manage your small business working capital so you know where to make changes in your business. With working capital management, you can continually monitor your current assets and current liabilities.
What is net working capital?
Working capital is the same as net working capital. However, there is a difference between gross working capital vs. net working capital.
Gross working capital is just your total current assets. It does not take current liabilities into consideration. Unlike net working capital, gross working capital does not show you your business’s ability to pay debts.
Calculating working capital
You need to know how to calculate working capital if you want to measure your business’s financial health. What is included in working capital?
Working capital formula
Here is the formula you need to know for calculating working capital:
Working Capital = Current Assets – Current Liabilities
Your working capital can either be a positive or negative number. A negative number shows that you do not have enough current assets to pay off current liabilities. A positive number shows you that you have enough current assets to cover current liabilities.
By using the net working capital formula, you can see the difference between current assets and current liabilities. That way, you know how much leftover money you have to work with for other unexpected expenses.
Examples of working capital formula
Let’s look at an example of positive working capital and negative working capital.
Positive working capital
You have $10,000 in current assets and $5,000 in current liabilities. Your formula would look like this:
$10,000 – $5,000 = $5,000
You have positive working capital, showing that you have more current assets than current liabilities. You can use the leftover money to invest in your business.
Negative working capital
Now, let’s say you have $5,000 in current assets and $10,000 in current liabilities. Your formula would look like this:
$5,000 – $10,000 = -$5,000
You have negative working capital. You do not have enough money to pay your current liabilities, which could slow your business down.
Working capital ratio
The working capital ratio is also known as the current ratio. Working capital ratio measures both your ability to pay short-term and long-term obligations. Unlike the working capital formula, the ratio shows you the proportion of assets to liabilities. Here is the current, or working capital, ratio:
Current Ratio = Current Assets / Current Liabilities
Your answer will be in decimal form. Anything below 1.0 means you are not able to meet your financial obligations. If you have a 1.0 or more, you have enough current assets to cover current liabilities.
Though you want your working capital ratio to be a 1.0 or more, you don’t want it to be above a 2.0. This can indicate that you are not investing assets.
Examples of working capital ratio
This business ratio can indicate a lot about your business debt management. Take a look at an example of a healthy current ratio and an unhealthy current ratio.
Healthy current ratio
You have $1000 in current assets and $700 in current liabilities. Here is how your current ratio would look:
$1000 / $700 = 1.4
Since your current ratio is between 1.0 and 2.0, you have more in assets than liabilities. But, you do not have too many excess assets, which is also good.
Unhealthy current ratio
You have $700 in current assets and $1,000 in current liabilities. Your current ratio would be:
$700 / $1000 = 0.7
Since your current ratio is below 1.0, you don’t have enough in current assets to meet your current liabilities.
How to obtain working capital
You know you need working capital to meet financial obligations and keep your business afloat. But, how do you get access to working capital?
If your current assets aren’t greater than your current liabilities, you need more working capital. You have a few options:
- Revolving lines of credit (e.g., credit cards)
- Debt financing (taking out loans)
- Equity (investors)
You can also refinance. Refinancing is when you take out a new loan to cover the old debt. The new loan has better terms and rates, so it’s easier to pay down. Taking on debt to pay off debt can be helpful, but it can also land you in more hot water, so do your research first.
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This article has been updated from its original publish date of June 30, 2015.
This is not intended as legal advice; for more information, please click here.