How To Calculate Working Capital

2019/06/20

Working capital highlights the operational efficiency of any company. Working capital is arrived by deducting a company’s current liabilities from its current assets. By using this formula, a company’s ability to meet its short term obligations/debt can be judged.

Positive working capital (when current assets exceed current liability) would generally indicate that company is able to meet its short term obligations using its current assets. On the contrary, a negative working capital would indicate that company’s current assets are not sufficient to cover its current liabilities. In adverse cases, this can result in a bankruptcy situation for a company.

To calculate working capital we need to understand the components of current assets and current liabilities. Current assets mainly comprise of cash and bank balance, accounts receivables (debtors) resulting from credit sales, inventory (raw material, work in progress, and finished goods), short term investments and prepaid expenses (expense which have been paid in advance). Current liabilities on the other hand mostly include accounts payables (creditors), outstanding liabilities (liabilities which have accrued but not paid) and short term loan (to be paid back within one year).

Let us take an example to show how working capital is calculated.

Suppose a company has following information available on its balance sheet:

Current Assets:
Cash: $ 20,000
Inventory: $ 50,000
Accounts Receivables: $ 75,000

Current Liabilities:
Accounts Payables: $ 50,000
Accrued Liabilities: $10,000

Total current assets are therefore $ 1, 45,000 while total current liabilities stand at $ 60,000. Taking these figures we arrive at a positive working capital of $ 85,000. This indicates that company has sufficient assets to pay for its current liabilities. Even though this may appear to be favorable from a company’s stand point, there could be a problem in actual discharge of liabilities as a major part of current assets is represented by inventory and accounts receivables which may not get converted into cash as and when required. Since too much money is blocked in these assets, if a liability has to be cleared immediately, company will have to use its cash which is not sufficient to cover entire amount of liabilities. This problem can be overcome by taking appropriate measures in form of fast collection of accounts receivables and quick turnover of inventory.

Let us consider a scenario where total current assets and total current liabilities stand at $ 50,000. Even though company’s working capital turns out to be nil ($50,000 – $ 50,000) in this case, still it cannot be said that company’s working capital position is not good. It is possible that company makes all of its sales in cash and has no accounts receivables. Also it is able to maintain a quick turnover of its inventory.

Working capital calculation is simple and can play a critical role in identifying the measures that may be required on part of the company to honor its short term commitments. Using this figure a company can better manage its assets and focus more on cash conversion cycle whereby it can ascertain the number of days it takes to convert its key current assets into cash. This will help the company in obtaining better understanding of its liquidity position.

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