How to Calculate Working Capital Needs Based on Business Cycles?
Having sufficient working capital is a measure of a company’s success. To operate a business effectively, one needs liquid assets to repay short-term liabilities within a limited time. Therefore, working capital is an indicator of an organisation’s liquidity levels required for day-to-day expenditure and inventory, accounts receivable and accounts payable.
A company can get working capital through revenue collection, debt management, inventory management, etc. They can also receive working capital through invoice discounting services from companies like KredX. This involves selling unpaid invoices to get instant access to cash.
The following sections will explain the basics of working capital and how to calculate the working capital needs of a company.
What Is Meant By The Term ‘Working Capital’?
‘Working capital’ indicates a company’s short-term financial status. To obtain the working capital of a specific firm, one has to subtract its current liabilities from its current assets.
Current liabilities refer to debt obligations usually payable within the end of a year, including short-term debt and accounts payable. Current assets are short-term assets that one can quickly convert into cash and includes inventory and accounts receivable.
The net working capital and working capital requirement formulae are two easy ways to calculate working capital needs. The working capital ratio is another important metric to consider.
Net Working Capital Formula
Net working capital (NWC) or net operating working capital (NOWC) is a business’s total current assets minus total current liabilities. If a company’s current assets exceed its liabilities, the company is financially sound and highly liquid in the short-term. Conversely, if it’s liabilities exceed its assets, it has a negative NWC and lacks liquidity.
The basic formula for this is given as follows:
Net working capital = Current Assets (excluding cash) – Current liabilities (excluding cash)
Working Capital Requirement
In case an analyst wants a more accurate calculation, he/she want to know the working capital requirement (WCR). This is a financial metric showing the costs of the production cycle, operational expenses and debt obligations. It shows how much money is needed to bridge the gap between payments to suppliers and payments received from customers.
The WCR formula is: Working capital requirement = Accounts receivable + Inventory – Accounts Payable
Working Capital Ratio
The working capital ratio is another important metric that shows a company’s ability to pay its current debt obligations using its current assets. It is a percentage that calculates working capital needs as a proportion between assets and liabilities. One can use the following formula to calculate this ratio:
Working capital ratio = Current assets / Current liabilities
A good working capital ratio ranges from 1.5 to 2 as it suggests a solid financial status. On the other hand, a working capital ratio less than one is negative as it indicates future liquidity problems.
However, if a business generates cash and sells products very quickly before payment to suppliers, it will not have a problem with a negative working ratio.
Working capital is a crucial financial metric that tells if a company can keep up its operations and cover its liabilities. Too little working capital indicates immediate liquidity problems, while too much working capital indicates inefficient usage of resources. Thus, it is necessary to calculate the working capital needs of a business to balance between efficiency and taking advantage of opportunities.