How to calculate working capital requirements?
Working capital requirement (WCR) is the amount of money that a company needs to run its business operations smoothly. It is calculated by subtracting the current liabilities (such as accounts payable, wages, taxes, etc.) from the current assets (such as cash, inventory, accounts receivable, etc.). A positive WCR means that the company has enough funds to meet its short-term obligations and invest in its growth. A negative WCR means that the company is facing liquidity problems and may need external financing.
To calculate working capital requirements, you can use the formula mentioned below:
Working capital (WC) = current assets (CA) – current liabilities (CL).
If the value of total current assets is Rs. 3,00,000 and current liabilities is Rs. 1,50,000, your company’s working capital will be 3,00,000 - 1,50,000, which equals to Rs. 1,50,000.
Some of the main constituents of the current assets of a company are:
- Cash in hand
- The stock or inventory the company holds
- Debtors have yet to pay their dues for purchasing goods from the company
- Expenses are paid for in advance
The current liabilities may comprise:
- Outstanding payments to creditors
- Other unpaid expenses
- Other short-term debts to be paid
Here is an illustration to help you understand working capital calculation:
Say that your business has the following current assets:
- Goods sold on credit: Rs. 2,00,000
- Raw materials: Rs. 2,00,000
- Cash in hand: Rs. 1,50,000
- Obsolete inventory: Rs. 40,000
- Loans given to employees: Rs. 50,000
The total value of the current asset would thus be a sum of the values given above except for cash in hand, i.e., Rs. 4,90,000. Available cash is the ultimate measure of liquidity and frequently changes with either receipt or payment. Adding it to the current assets does not accurately portray a business's liquidity.
Say that your current liabilities include:
- Outstanding funds payable to creditors: Rs. 1,70,000
- Unpaid expenses: Rs. 80,000
The total value of current liabilities thus stands at Rs. 2,50,000 (A sum of the above two values).
Using the working capital formula, you can estimate the business's liquidity status.
WC = CA – CL
= Rs. 4,90,000 – Rs. 2,50,000
= Rs. 2,40,000
With the help of this formula, a business can estimate the working capital it has. In case of a deficit, the business owner can opt for a working capital loan to meet the expenditure requirements.
Bajaj Finserv brings a high-value loan of up to Rs. 80 lakh* (*inclusive of insurance premium, VAS charges, documentation charges, flexi fees, and processing fees) to help a business fund its working capital needs and operate at optimum efficiency. Avail of the loan and repay affordably with competitive interest rates on offer.
Additional Read: Importance of capital budgeting
Positive vs negative working capital
Positive working capital is essential for a successful business operation, as it enables companies to cover their short-term obligations and invest in future growth opportunities. When a company has more short-term assets than liabilities, it has positive working capital.
Meanwhile, negative working capital can create cash flow problems, making it challenging for the business to pay bills and creditors on time. It may also negatively affect the company's credit rating and limit access to future financing.
A business owner can improve their company’s positive working capital by taking out a working capital loan. It can boost liquidity and provide the necessary funds to cover short-term obligations.
List of working capital formulas
Calculating working capital is key to managing a business's finances effectively. Below are some commonly used formulas that businesses can use to determine their working capital needs:
- Working capital: Calculate by subtracting current liabilities from current assets.
- Net working capital: Calculate by subtracting current liabilities (minus debt) from current assets (minus cash).
- Operating working capital: Calculate by subtracting non-operating current assets from current assets.
- Non-cash working capital: Calculate by subtracting current liabilities from current assets (minus cash).
- Change in working capital: Measure the difference between the previous and current year's working capital.
By using these working capital formulas, businesses can more accurately assess their financial health and identify their working capital requirements. This can help make informed decisions and better manage cash flow, leading to greater success and reducing the need for external financing like working capital loans.
Adjustments to the working capital formula
Businesses can adjust the working capital formula to improve the accuracy of their assessment. These adjustments include:
- Factoring in cash reserves to current assets.
- Excluding inventory from the working capital calculation in the case of financing options.
- Excluding non-operating assets such as long-term securities and investments.
- Seasonal adjustments to account for inventory and accounts receivable fluctuations.
- Considering debt maturity for better working capital requirement calculation.
By adjusting the working capital formula, businesses can better determine their financial position and calculate working capital requirements accurately.
What is a good working capital ratio?
A good working capital ratio is generally between 1.2 and 2. A ratio above 2 may indicate that a business has too much inventory or is not investing in growth opportunities. Conversely, a ratio below 1.2 may indicate that a business has too little liquidity to meet its short-term obligations. However, a "good" working capital ratio can vary depending on the industry, business size, and other factors. Therefore, it is important to factor in these considerations and use other financial ratios to assess a business’s financial health and working capital needs.
Importance of using the working capital formula
Working capital formulas are essential for businesses to assess their current financial position and understand their working capital requirements. By using these formulas, businesses can:
- Monitor and manage cash flow effectively.
- Identify areas where they need to improve their financial efficiency.
- Reduce the need for external financing such as working capital loans.
Overall, the use of working capital formulas enables businesses to make better-informed decisions and optimise their financial performance, leading to greater stability and success in the long term.
