Working Capital: Definition, formula & examples

In the world of business finance, working capital is the lifeblood that keeps companies running smoothly.

Yet, many companies are unknowingly sitting on a goldmine of untapped potential.

A recent J.P. Morgan study (2022) revealed a staggering truth: S&P 1500 organizations across industries are leaving more than $520 billion in estimated working capital on the table due to significant inefficiencies in management.

Let that sink in for a moment. Half a trillion dollars, just waiting to be unlocked. It's time to stop losing precious money and make your working capital do the job for you.

In this post, we're cutting through the financial jargon to show you exactly how to tap into this hidden resource.

‍No fluff, no filler: just straight-up, actionable advice to help you squeeze every last drop of efficiency from your working capital.

‍Whether you're a seasoned CFO or a startup founder, buckle up. We're about to take you on a ride that could revolutionize your business's financial flexibility.

What is working capital?

Working capital - or net working capital (NWC) - is a measure of a company's liquidity.

It's the difference between a business's financial assets (anything it owns or is owed) and liabilities (anything it owes). 

So, a firm can have either positive working capital (suggesting it can afford to pay its debts and invest in its growth) or negative working capital (indicating it may be struggling).

Expand your horizon: 5 tips for securing the capital you need to scale your business.

How to calculate working capital

Calculating a firm's working capital is simple. Subtract its current liabilities from its assets.

NWC formula

Net Working Capital (NWC) = current assets - current liabilities

The result can be either a positive or negative number.

This figure is used to determine a business's financial risk profile.

Considerations when calculating working capital

When applying the working capital formula, it's important to consider the company's current assets. These may include:

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

Once the total value of these assets is calculated, the company must subtract the cost of its liabilities.

This is everything the company 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's net working capital (NWC). 

Positive NWC: you're in the green

When your net working capital is positive, you've got more current assets than current liabilities. In plain English?

You've got enough cash and assets to cover your short-term debts and then some.

It's like having money left in your pocket after paying all your bills.

Businesses with positive NWC are typically in a good position to expand, invest, or weather unexpected financial storms.

Negative NWC: you're skating on thin ice

A negative net working capital means your current liabilities outweigh your current assets.

You're short on cash to cover your immediate obligations. It's like maxing out your credit cards and struggling to make minimum payments.

While some companies (like Amazon) intentionally operate with negative NWC, for most businesses, it's a red flag that screams "cashflow problem!"

Working capital calculation: example #1

Let's crunch some numbers. Say Company X has:

• Current Assets: $500,000
• Current Liabilities: $300,000
• NWC = current assets - current liabilities
• NWC = $500,000 - $300,000 = $200,000
  

Boom! Company X has a positive NWC of $200,000. They're not just treading water; they're swimming laps around their competitors.

Remember, working capital isn't just a number - it's your business's pulse.

Keep it strong, and you'll be ready to seize opportunities or fight off financial threats at a moment's notice.

Ignore it, and you might find yourself gasping for air when the market takes an unexpected dive.

Money should be your best ally, not your Achilles heel. Find out how you can improve this relationship on: Cashflow solutions to accelerate payment on invoices.

Working capital calculation: example #2

ABC Ltd wants to see how much money it has available to invest in growth so it decides to calculate its net working capital.

Firstly, ABC Ltd totals the value of its assets such as property and product stock, plus everything it is owed such as unpaid invoices. ABC calculates that these assets total $1 million (USD).

Next, ABC Ltd adds up its liabilities, including debts, overheads, operating expenses, and any invoices it has to pay. ABC Ltd works this out to be $750,000 (USD).

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

$1 million (USD) - $750,000 (USD) = $250,000 (USD)

ABC Ltd calculates that it has $250,000 (USD) in positive working capital.

Therefore, it can confidently and comfortably afford its outgoings and invest in growth.

Why is working capital important?

Working capital is important for the following reasons:

• It helps companies assess whether they can afford their outgoings
• It also helps business owners understand if they're at financial risk
• It provides a useful baseline figure on which to gauge performance
• It's a good key performance indicator (KPI) for a business
  

Reasons why a company may need working capital

Additional capital would benefit every business but some companies in specific industries may need fast access to it.

These situations could include the following:

• To fund initial growth: SMEs might need to hire new talent and pay overheads as they expand into new facilities.
• Financing bulk orders: Some suppliers may provide limited-time offers to their buyers and liquid capital may be needed to finance such offers.
• Peak times: For many companies, outgoings are higher during certain times of the year, such as when annual taxes or deferred payments are due. Liquid capital helps companies fulfill these obligations.
• Seasonality: Many companies experience seasonal fluctuations and may need liquid capital to keep them afloat during quieter periods.

What are working capital cycles?

A working capital cycle is the time it takes a business to turn its assets and liabilities into cash. 

Working capital cycles are different for each company. They depend on the terms of both accounts receivable and accounts payable, and on how long the company holds stock before selling it.

Many companies prefer shorter working capital cycles because they allow easier access to liquid capital to invest in the company.

Longer working capital cycles often leave businesses operating for months with valuable cash tied up. 

It's difficult to achieve the ideal working capital cycle, particularly if a company sells and ships goods internationally.

International buyers often demand deferred payment terms (sometimes up to 120 days) which can leave suppliers (especially those in emerging markets) with very little income until invoices are paid.

Alternative working capital formulas 

The traditional working capital formula is straightforward.

However, there are some other calculations that can give companies a better idea of how to cover their costs.

Working capital ratio

This is a formula that shows the proportion of assets against liabilities.

Instead of subtracting liabilities from assets, the company should divide the value of assets by the value of liabilities.

If the working capital ratio is one or lower, that could suggest the company may struggle to cover costs, while ratios of two or higher suggest the company is performing well.

Adjusted working capital

Some companies prefer to calculate NWC using an adjusted formula. It's the same formula as the standard NWC calculation but liquid capital is not included in assets.

This then shows whether a company's short-term assets and liabilities are reasonable and sufficient. 

What are examples of working capital?

• Cash and cash equivalents (the lifeblood of your business)
• Accounts receivable (money owed to you - get it in!)
• Inventory (stuff you need to sell)
• Short-term investments (your rainy-day fund)
• Accounts payable (what you owe others - keep it in check)
• Short-term debt (the necessary evil)
• Accrued expenses (the sneaky costs)
• Prepaid expenses (future benefits you've already shelled out for)

4 ways to increase working capital

Companies might want to increase NWC to fund new opportunities, grow into new markets, serve new customer sectors, or avoid bad debt. 

Increasing working capital can be achieved by:

1. Purchasing trade credit insurance to protect the supplier against non-payment from its buyers.
2. Paying off short-term debts to secure the company financially and increase capital in the longer term.
3. Reducing liabilities where possible, such as buying stock in bulk to take advantage of supplier discounts, paying invoices early (sometimes suppliers offer early payment discounts), avoiding stockpiling, and leasing rather than buying equipment.
4. Using non-recourse invoice factoring where a factoring company will supply cash up to the value of an unpaid invoice and then chase the buyer for payment.

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