Understanding your business's working capital is essential to maintaining its health and safeguarding its future. The capital account balance formula can help you derive your working capital from your balance sheet.
The Capital Account Balance Formula
The basic capital account balance formula for working capital is straightforward, and it is presented by the writers from the Corporate Finance Institute as Working Capital = Current Assets - Current Liabilities. This gives a metric of your business's short-term liquidity, meaning how much cash or assets easily convertible to cash your business has available after discharging short-term liabilities. However, calculating it accurately requires understanding what goes into the formula.
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The Corporate Finance Institute summarizes the categories: cash, accounts receivable, inventories for current assets and accounts payable, short-term borrowings and accrued liabilities. However, there's a fair amount of detail as to what elements comprise these categories.
The team at Oracle Netsuite provides cloud-based software for financial management and has a page explaining what goes into working capital. For example, current assets can also include raw materials as part of inventory, plus marketable securities such as money market funds and U.S. Treasury bills. Accounts receivable should also allow for accounts that are unlikely to be paid. Likewise, a major element in the current liabilities category is wages.
Positive vs. Negative Working Capital
Calculating your capital account working balance is the first step to many types of financial monitoring and to predicting your cash flow. Having an estimation of balances related to the capital account lets you compute working capital ratios that creditors deem important.
Writers for The Business Development Bank of Canada define working capital as the money you need to cover short-term expenses, specifically excluding longer-term concerns such as research and development. The working capital ratio is one important measure of your business's ability to pay the bills and keep functioning.
It is defined as your current assets divided by your current liabilities. For example, if you have $250,000 in current assets and $125,000 in current liabilities, then your working capital ratio is 2.0. Creditors like to see working capital ratios of around 2.0 or higher. A working capital ratio of 1.0 usually means you are struggling to pay the bills and keep operating from one period to the next.
Using the Quick Ratio
Another related ratio is the "quick ratio," which is a more stringent measure of liquidity that excludes unsold inventory. Writers at The Corporate Finance Institute provide two formulas for this (also called the acid test or liquidity ratio): Quick Ratio = (Cash + Cash Equivalents + Marketable Securities + Accounts Receivable) / Current Liabilities or Quick Ratio = (Current Assets – Inventory – Prepaid Expenses) / Current Liabilities.
In the example, if $100,000 of your current assets are in inventory, then your quick ratio would be 1.2. A ratio above 1.0 means your business has enough cash and liquid assets to cover day-to-day operations.
As seen from these ratios, positive working capital is a generally positive indicator and leads to ratios of 1.0 or above. What if you have a negative working capital balance, meaning your ratios will be below 1.0? How dire this is depends on the business and sector. Establishments like large retail stores or fast-food restaurants can survive negative working capital because they can raise a lot of money in sales quite quickly. Likewise, working capital for many businesses fluctuates with the seasons or other outside factors. However, it's still best to sustain positive working capital and high ratios whenever possible. The Oracle Netsuite article provides several ideas for increasing working capital.