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Working Capital – Definition & Calculation Formula

April 6, 2022

What is working capital?

Working capital – or ‘net working capital’ (NWC) – is a measure of a business’ liquidity. 

It’s the difference between a business’ current assets (anything the business owns or is owed, like cash and accounts receivable) and its liabilities (everything it owes). The assets considered when working out NWC are typically those that are either due to be cashed in or paid out in the next year.

So, a business can either have positive working capital – allowing it to pay its bills and debts and invest in its growth – or negative working capital.

 

How to calculate working capital

Calculating working capital is simple. To understand a business’ current NWC, simply subtract its current liabilities (everything it owes) from its current assets (everything it owns or is owed).

The formula looks like this:

Current assets – current liabilities = net working capital (NWC)

The result can be either a positive or negative figure and is used to determine a business’ financial risk profile. Positive working capital suggests a business can afford its debts and is in a position to facilitate growth, while negative working capital indicates a business may be struggling.

However, as we’ll explore in this guide, it’s not always black and white…

 

Considerations when calculating working capital

When calculating NWC, we must first consider a business’ current assets. These may include:

  • Liquid capital (cash flow).
  • Stock and inventory.
  • Property.
  • Accounts receivable (unpaid invoices owed by customers).

Once a business has totalled the value of its assets it must subtract the cost of its liabilities. This is everything the business owes and may include:

  • Overheads like rent and utility bills.
  • Employee salaries.
  • Tax.
  • Debts.
  • Accounts payable (unpaid invoices owed to its suppliers).

The resulting sum is the business’ net working capital.

 

Example of working capital

ABC Ltd. wants to calculate its net working capital to assess how much it has available to invest in growth.

Firstly, ABC totals the value of its owned assets, plus everything it is owed. This includes its property, the value of its product stock, its cash and its accounts receivable (invoices it has yet to be paid for). ABC calculates that these assets total $1,000,000.

Next, ABC totals the value of its liabilities – including its debts, overheads, operating expenses and accounts payable (invoices it has yet to pay). ABC works this out to be $750,000.

Finally, ABC subtracts the value of its liabilities from the value of its assets:

$1,000,000 – £750,000 = $250,000

ABC calculates that it has $250,000 in positive working capital – so it can confidently and comfortably afford its outgoings and invest liquid capital in growth.

 

Why is working capital important?

Working capital is important because it helps businesses to understand whether they can afford their outgoings and ‘keep the lights on’ or whether they are at risk of not being able to pay their bills.

Calculating a business’ net working capital gives it a useful baseline figure to gauge performance and risk. For example, if a business has significant positive working capital then it knows it can afford to reinvest liquid capital in growing its operations.

However, negative working capital suggests that the business is spreading itself too thin and may need to adjust its business model to avoid financial punishment or even bankruptcy.

So, it’s important to regularly review working capital and use it as a key performance indicator together with other financial calculations.

 

Reasons why a business may need additional working capital

While every business would like some extra cash, there are many common situations in which a business – especially in certain industries – may reasonably need to access greater working capital. These may include:

  • SMEs may simply need additional liquid capital to fund growth in their early days. For example, to hire new talent and pay overheads as they expand into new facilities.
  • Manufacturers or retailers may occasionally need liquid capital to finance bulk orders from suppliers. For example, to take advantage of limited-time offers.
  • For many businesses, outgoings increase during certain ‘peak’ times of the year. This may include paying annual taxes or meeting deferred payment terms.
  • Many businesses experience seasonal fluctuations, such as some hospitality and leisure services, and may need to generate additional capital during the busy season to keep them afloat during the quieter season.

Stenn helps businesses increase their NWC by turning their accounts receivable into liquid capital. This allows them to pay suppliers on time, fund growth and avoid negative working capital by freeing up cash that’s frozen in unpaid invoices.

As a non-recourse factoring provider, Stenn also protects suppliers against the risk of non-payment of those invoices.

Find out more about how businesses can increase their working capital below.

 

Working capital cycles

A working capital cycle is the amount of time it takes a business to turn its assets and liabilities into cash. Working capital cycles are different for each business and depend on respective payment terms for accounts receivable and payable, plus how long it holds stock before it is sold.

Shorter working capital cycles are helpful for businesses, giving them liquid capital to invest elsewhere in order to grow. Longer working capital cycles leave a business’ assets tied up in accounts receivable and payable.

Stenn helps businesses enjoy shorter working capital cycles by turning their accounts receivable into liquid capital – which they can use to pay debts sooner and fund growth.

 

Alternative working capital formulas 

Aside from the traditional working capital formula, other calculations also give businesses a clearer understanding of their ability to cover their costs.

Working capital ratio

One alternative is calculating a working capital ratio – a formula that is used to show the proportion of a business’ assets compared with its liabilities. When calculating a working capital ratio, a business should divide the value of its assets by the value of its liabilities (instead of subtracting):

Current assets / current liabilities = working capital ratio

A working capital ratio of 1 or less suggests that a business may struggle to cover its costs, whereas a ratio of 2 or more suggests a strong financial position.

Adjusted working capital

Some businesses prefer to calculate their net working capital using a slightly adjusted formula. ‘Adjusted working capital’ simply discounts a business’ liquid capital when totalling its assets.

The rest of the formula stays the same. The objective of ‘adjusted working capital’ is to show whether a business’ short-term assets and liabilities are reasonable and sufficient to keep the business operating.

The following is an example of how a business might calculate its adjusted working capital:

XYZ Ltd. wants to calculate its adjusted working capital. Firstly, it totals all its owned assets (except for liquid capital) plus everything it is owed. This may include its property, the value of its product stock, and its accounts receivable (unpaid invoices). XYZ calculates that these assets total $500,000.

Next, XYZ totals the value of all its liabilities, such as debts, overheads and operating expenses. XYZ works this out to be $400,000.

Finally, XYZ subtracts the value of its liabilities from the value of its assets:

$500,000 - $400,000 = $100,000

XYZ calculates that it has $100,000 in positive adjusted working capital – giving the business confidence that it is capable of maintaining performance.

 

Ways to increase working capital

Businesses may look for ways to increase their NWC to fund new opportunities, grow into new markets, serve new customer segments or simply to avoid bad debt. 

Increasing working capital may be achieved by:

Leveraging accounts receivable and payable – businesses can use invoice factoring services to sell invoices with deferred payment terms (of up to 120 days) and receive immediate liquid capital. This can also protect businesses against non-payment if they use ‘non-recourse’ factoring. Similarly, delaying accounts payable can improve a business’ short-term NWC.

Protecting against non-payment – aside from using non-recourse factoring agreements, businesses can also protect themselves against non-payment by credit checking all new customers and purchasing trade credit insurance.

Paying off debts – many businesses are laser-focused on their growth and use any liquid assets they have to fund new ventures. However, paying off bad debt in the short term can set them up for a stable financial future, increasing long-term NWC.

Reducing expenditure – reducing the value of liabilities obviously increases a business’ NWC, so businesses should review all outgoings for viable ways to reduce expenditure. This may include buying in bulk to take advantage of supplier discounts, avoiding stockpiling and leasing equipment instead of buying.

 

How can Stenn help with working capital?

Stenn helps businesses increase their working capital by turning their accounts receivable into liquid capital.

We provide financing for SMEs which trade internationally – especially those with much of their assets tied up in accounts receivable. We provide funds with which they can pay their suppliers on time and fund their growth.

If your  business deals with invoices using deferred payment terms, Stenn can help you avoid negative working capital by freeing up liquid capital. As a non-recourse invoice factoring provider, Stenn protects suppliers against non-payment. We take on the risk and the responsibility of chasing the customer for payment.

 

About the Authors

Stenn is a registered member of the ITFA, IFA and WOA. It has financed invoices worth over $7 billion (USD) to date and provides:

  • An online platform for easy applications.
  • Non-recourse factoring (i.e. full protection against non-payment of invoices).
  • Rapid assessments (usually within 15 minutes).
  • Cash advances within 48 hours, with only two documents to sign.
  • Advances of between $10K (USD) to $10M (USD).
  • Fees that begin at 0.65%.
  • Advances on international deals that other companies and banks can’t, or won’t, finance.
  • Services in 74 countries.
  • Reverse factoring (buyers can use Stenn to pay immediately and settle the invoice later with us).

This article is authored by the Stenn research team and is part of our educational series.

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Disclaimer: The above article has been prepared on the basis of Stenn’s understanding of current invoice factoring. It is for information only and doesn’t constitute advice or recommendation. Whilst every care has been taken in preparing this article, we cannot guarantee that inaccuracies will not occur. Stenn International Ltd. will not be held responsible for any loss, damage or inconvenience caused as a result of anything published above. All those applying for credit should seek professional advice when doing so.

 

Discover our other guides

To find out more about different types of trade finance, check out our other informational guides.

Alternatively, contact our team of friendly invoice factoring experts to discover if Stenn can support you with your unpaid invoices.