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 company'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).
How to Calculate Working Capital
Calculating a firm's working capital is simple. Subtract its current liabilities from its assets.
The formula is as follows:
Current assets - current liabilities = net working capital (NWC)
The result can be either a positive or negative number. This figure is used to determine a business's financial risk profile.
However, there is more to working capital than this simple explanation.
Considerations When Calculating Working Capital
When calculating NWC, it's important to consider the company's current assets. These may include:
- Liquid capital
- Stock and inventory
- 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
- Accounts payable (unpaid invoices owed to its suppliers)
The resulting sum is the business's net working capital (NWC).
Example of Working Capital
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 more working capital.
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 fulfil these obligations.
- Seasonality. Many companies experience seasonal fluctuations and may need liquid capital to keep them afloat during quieter periods.
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 companies 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 which 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 1 or lower, that could suggest the company may struggle to cover costs, while ratios of 2 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.
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:
- Purchasing trade credit insurance to protect the Supplier against non-payment from its Buyers.
- Paying off short-term debts to secure the company financially and increase capital in the longer term.
- 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.
- 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.
If you are interested in learning more about invoice factoring, Stenn has a dedicated FAQ section where you can find more information about our invoice financing services. We also provide videos which explain the company and the financing process in detail.
About the Authors
This article is authored by the Stenn research team and is part of our educational series.
Stenn is the largest and fastest-growing online platform for financing small and medium-sized businesses engaged in international trade. It is based in London, provides financing services in 74 countries and is backed by financial giants like HSBC, Barclays, Natixis and many others.
Stenn provides liquid cash to SMEs within the global financial system. On stenn.com you can apply online for financing and trade credit protection from $10 000 to $10 million (USD). Only two documents are required. No collateral is needed and funds are transferred within 48 hours of approval.
Check the financing limit available on your deal or go straight to Stenn's easy online application form.
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