Working Capital: Formula, Examples, and Nuances Explained

What is Working Capital?

Working capital is a fundamental concept of business finance that provides a measure of the short-term financial health and liquidity of a firm. Working capital represents the money available to a business to cover its daily operational expenses, such as purchasing inventory, paying suppliers, and meeting other short-term obligations. Essentially, working capital is a measure of a company’s ability to meet its short-term financial obligations and can be an indicator of the financial health of a firm.

How to Calculate Working Capital

The formula for calculating the value of working capital is:

Current Assets – Current Liabilities = Working Capital

Current Assets

Current assets are the resources a company expects to turn into cash or use in the next 12 months. These assets are more liquid than long-term assets such as property. Some examples of current assets include cash, cash equivalents, accounts receivable, and inventory.

Cash and Cash Equivalents include physical money (monetary notes and coins), cash stored in business checking or savings accounts, and highly liquid investments that can be converted into cash fairly easily.

Accounts Receivable are the invoices owed to the business by its customers for goods or services provided on credit. Accounts receivable can significantly impact a company’s working capital, as accruing a large number of outstanding balances can tie up funds that would otherwise be used for day-to-day operations. If an invoice is unlikely to be paid, it is best practice to subtract that amount from the accounts receivable total.

Inventory refers to all of the goods the company has created to be sold and the raw materials waiting to be used in the production process. Efficient inventory management is essential to maintaining a healthy working capital level.

Current Liabilities

Current liabilities are the obligations the company expects to settle within the next 12 months. This includes accounts and wages payable, short-term debts and taxes, deferred revenues, and more.

Accounts Payable is the money owed by the business to its suppliers for goods, services, and rent received on credit.

Short-Term Debt refers to the loans the company has yet to repay that are due within the next 12 months. This could be the portion of a long-term debt scheduled to be paid within 12 months, or a short-term loan that is opened and paid within the 12-month window.

Wages Payable refers to the amount of money owed to employees that has been earned but not yet paid.

Deferred Revenues relate to the money received before services are performed or products are delivered. This is a current liability because, although the cash from a transaction may be in the company’s bank already, the business has an outstanding obligation to complete the contracted service(s) or deliver the purchased product(s) before revenue can be realized.

Accrued Tax Payable is the tax to be paid within the next 12 months.

Working Capital Limitations

While working capital offers a high-level measurement of how a company is managing its current assets and liabilities, some elements are not taken into consideration, such as the dynamic nature of liquid assets and the breakdown of where the value is placed.

Working capital is used in day-to-day operations, meaning the actual working capital is always changing even if it is not being reported. Since the process of collecting all of the information on current assets and liabilities can be lengthy, there is a chance the real value of the working capital of a company has changed by the time the number is recorded.

Accounts receivable offer another set of nuances in the working capital reporting process. The dollar amount of working capital cannot fully express the nature of accounts receivable; if a debtor or client with outstanding amounts due goes bankrupt or takes a long time to pay off the invoice(s), the providing company’s working capital will decrease. Thus, if the majority of a business’s current assets are in accounts receivable, the amount of actual liquidity may be limited.

Other aspects of current assets that may reduce the accuracy of reporting working capital are the risk of poor inventory management and theft. If the company cannot efficiently track inventory and pieces go missing, the real working capital amount will differ from what the company has in its books.

When it comes to keeping track of current liabilities, it is necessary to accurately record all outstanding payments. Implementing company-wide practices to streamline the accounting process will help ensure no debts, big or small, go unaccounted for, resulting in a more accurate working capital figure.

Working Capital Needs by Industry

Understanding the working capital needs specific to your industry is vital for effective financial management. As we explore the different working capital needs between industries, it is important to be mindful that there will always be variance in the optimal working capital amounts, as businesses maintain various sizes, suppliers, and customers with unique needs.

Manufacturing Industry: Manufacturers typically require significant working capital to fund inventory purchases, raw material costs, and production expenses. The length of the production cycle and the time it takes to convert raw materials into finished goods impact working capital needs. Efficient inventory management, just-in-time practices, and streamlined production processes can help optimize working capital in the manufacturing sector.

Retail Industry: Retail businesses often deal with fluctuating customer demand, seasonal trends, and inventory management challenges. The ability to accurately forecast demand, maintain optimal inventory levels, and negotiate favorable payment terms with suppliers are crucial factors in managing working capital effectively in the retail sector.

Service Industry: Service-based businesses, such as consulting firms or IT service providers, typically have fewer working capital needs compared to manufacturing or retail. Since their revenue is primarily generated through the provision of services rather than the sale of physical products, their inventory requirements are minimal. However, managing accounts receivable and maintaining a steady cash flow are key for service businesses to ensure sufficient working capital.

Construction Industry: The construction sector often faces unique working capital challenges due to long project cycles and high upfront costs. Contractors and construction companies need to manage cash flow carefully, as they often have to pay for labor, equipment, and materials before receiving payment from clients. Effective project cost estimation, accurate billing, and prompt collections are crucial for maintaining healthy working capital in the construction industry.

Example of Working Capital

Last year, Bart’s Bike Shop reported $100,000 in current assets. This amount comprises all of the accounts receivable, short-term investments, cash, and inventory involved in Bart’s business. Bart’s shop also has $60,000 of current liabilities. This number comes from Bart owing the bike parts distributor for the parts he received in advance, the rent he pays for his storefront, his estimated wages payable, and some short-term taxes.

$100,000 – $60,000 = $40,000 of Working Capital

The working capital Bart’s Bike Shop has is $40,000. This means if Bart had to pay off all of his $60,000 in liabilities, he would still have $40,000 left over. Bart works hard to maintain a healthy working capital level so he can cover the daily expenses of his bike shop, but he is actively looking for ways to improve his working capital management.

How to Improve Working Capital

Maintaining healthy working capital levels is a full-time job! Due to the dynamic nature of current assets and liabilities, the process of maintaining optimal working capital levels requires continuous strategic financial management. Some strategies you may consider to improve working capital levels include:

Inventory Management: Implement inventory control systems to avoid excess inventory and minimize carrying costs. Regularly analyze demand patterns, improve forecasting accuracy, and negotiate favorable terms with suppliers to efficiently manage inventory levels.

Accounts Receivable Management: Form comprehensive credit policies, conduct credit checks on customers, and monitor receivables closely. Timely invoicing, proactive collections, and offering incentives for early payments can help improve cash flow and reduce the risk of default on receivables.

Accounts Payable Management: Try to extend payment terms with suppliers without negatively impacting relationships. Negotiate favorable discounts for early payments and optimize payment schedules to maintain a healthy cash flow.

Cash Flow Forecasting: Develop accurate cash flow projections to anticipate shortfalls or excess liquidity. This will allow you to make proactive decisions and help identify potential working capital needs in advance.

Efficient Working Capital Cycle: Find ways to streamline business processes and minimize the time it takes to convert inventory into sales and receivables into cash. Identify and eliminate bottlenecks or inefficiencies in the operational workflow to enhance cash conversion cycles.

Working Capital Financing

A business with limited working capital may choose to borrow money in order to cover daily operational expenses, to offset slow periods in a seasonal or cyclical industry, or to invest its capital into growth and expansion opportunities that will take the business to the next level.

To increase working capital, businesses will look to increase current assets without adding to current liabilities. A multi-year Small Business Term Loan or Business Line of Credit can be a fit for companies needing a relatively small ($30,000 to $300,000) infusion of cash as a bridge loan or capital investment for their business. Companies with larger, ongoing needs might prefer to leverage their Accounts Receivable and other current assets to gain access to credit without incurring additional debt (liabilities). In those cases, Business Invoice Factoring or Asset-Based Lending could be a better option.

Working Capital Cost-Benefit Analysis

As with any business venture, it is recommended to perform a cost-benefit analysis before incurring debt or entering a new financial arrangement. A few questions to ask yourself before signing a working capital financing agreement include:

• What is the cost of the working capital financing (borrowing rates and fees)?
• How much incremental revenue is expected to be generated from this financing opportunity?
• How much potential revenue could be lost if working capital is not financed?
• How will pursuing or forgoing the agreement impact intangible assets?

Cost-benefit analyses are an in-depth process that should be performed by a financial expert. Working capital financing should be pursued only in cases where the expected benefit outweighs the anticipated costs.

Financing That Goes Further

TAB Bank offers an array of working capital financing solutions for small to medium-sized businesses. If you are looking for ways to bridge the working capital gaps your business is facing or to invest in your company’s growth, TAB Bank is here for you.

With our unique approach to customized financing, we can fund deals that other banks can’t. When we see a business coming from a bank that is overcollateralized, we are often able to help that business find new funding with one of our loan options. We have many working capital solutions to aid businesses in their operational efficiency and growth.

Learn more about TAB Bank’s flexible financing solutions made to fit your business’s needs.