Working Capital Management – Definition, Formula and How to Calculate

Yarab A |Updated on: July 4, 2022

Working capital is the fuel which runs the business. To ensure business continuity and sustained growth, you need working capital. Not managing your working capital efficiently, will severely impact the day-to-day operations of the business.

In this article, we will learn and understand:

• What is working capital?
• What is working capital management
• Formula to calculate working capital?
• How to calculate working capital ratio?
• How working capital impacts your business?
• Objectives of working capital management
• Working capital management solutions

What is working capital?

Working capital refers to money available for carrying on the day to day business operations. Working capital represents the financial liquidity of the business. It is often said that the way you manage working capital will make a big difference in the growth and continuity of business.

The concept of working capital includes current assets and current liabilities. The difference between these two is the working capital available for business to fund its daily operations and seed further growth.

What is working capital management?

The working capital that a company has to work with is calculated as its current assets minus current liabilities. Working capital management is the tools and techniques used by a company to make the best use of these assets and resources in order to meet the company’s goals and targets, maintain good cash flows and meet all obligations. Good working capital management also keeps cash flowing, thus enabling the company to generate enough cash to fuel its own growth rather than raising debt from outside. The company’s growth can be achieved by funneling its extra money into acquisitions, R&D, product development, mergers or other growth prospects that are viable at the time. 

Working capital management is the everyday process of managing all the aspects of the company’s cash flow to be able to pay for expected and unexpected expenses. It involves the proper management of accounts receivable, accounts payable, cash and inventory. 

Formula to calculate working capital?

To calculate working capital, you need to consider all the current assets and current liabilities of the business. Current assets are those which you can convert into cash in the short-term, usually, 1 year and current liabilities include all short-term debts. Following are some of the major attributes of working capital.

• Current assets
  • Cash
  • Bank
  • Inventories
  • Accounts receivables
  • Any other short-term receivables
    
    
• Current liabilities
  • Accounts payable (Amount you owe to suppliers)
  • Any other short-term debt

The formula to calculate working capital is given below

Working Capital = Current Assets – Current Liabilities.

Working capital is simply a difference between your current assets and current liabilities. If your current assets exceed current liabilities, it said to have positive working capital. Else, it is negative.

How to calculate working capital ratio?

The working capital ratio gives quick insights about the health of the business in terms of ratio. The working capital ratio is derived by dividing the current assets by current liabilities.

Working Capital Ratio = Current Assets/Current Liabilities.

Working capital ratio of above 1 indicates the business has enough cash to pay its short debts. Similarly, a working capital ratio below 1 indicates negative working capital and business is facing some sort of financial difficulties in paying their debts.

How working capital impacts your business?

The way you manage your working capital will make a big difference to your business. Managing working capital is always a question of sufficient or deficient? As stated above, a positive working capital ratio indicates the business is well-positioned to pay its short-term debts. While a negative working capital reflects the financial difficulties to settle short-term debts.

The high working capital ratio is also not always a good thing for business. This indicates the business has too many inventories and struggling to sell those. It may also indicate the business takes a long time to convert its accounts receivables into cash. It also represents you have extra cash that you should invest in other areas of business. Holding extra by not investing is not a smart decision of your money.

In the end, it all boils down to How much working capital is enough? The need for working capital is directly linked to the growth of the business. You need to answer this question considering serval attributes of working capital discussed above.

You need to be smart in managing the different components of working capital to have a positive impact. There are 3 key things which matter most to have strong working capital. Figure out these things by reading ‘3 Key Areas to Strengthen Working capital of your business’

Objectives of working capital management

A company's management should carefully monitor the working capital to have adequate money to operate the company, pay dues and be prepared for any unexpected costs. There are also other aims of working capital management as follows:

●     Meet obligations: A company should always have enough money, or liquidity to pay its dues. This can be achieved by preventing any delays in collecting payments from customers. The company should also have enough extra money on hand to pay unexpected costs. 

●     Growth and expansion: In addition to keeping the business operational, working capital management must also try to continually plan for the company’s growth through development, R&D or acquisitions. If the company has too much of its money locked into inventory or assets, there will not be sufficient liquidity to fuel any expansion. This would mean that a company must be a little less cautious in its financial management to maintain liquidity. 

●     Optimize capital performance: A company should strive to make the best use of its capital. This may require that the company minimize capital cost expenditure and maximize its capital returns. Taking steps to reclaim and unlock capital locked in assets is an example of a strategy to make the working capital as liquid and usable as possible. 

Working capital management solutions

Business solutions for capital management help improve the company’s processes and systems so that they have more liquidity, cash flow and better capital management. Some of the working capital solutions are:

Electronic invoicing: A customer will only pay after their invoice has been raised and delivered. If a company has an inordinate delay in the process of creating an invoice, the entire collection of cash process is delayed at the start. If the invoice is raised inaccurately, the process of correcting it wastes more time. So, a streamlined and improved invoicing system is a good way to speed up accounts receivable. TallyPrime’s invoicing system is quick and efficient and helps your company handle high invoices volumes efficiently. It also integrates with accounts and updates the appropriate ledgers when required without any data re-entry. 

Cash flow forecasting: It is easier to manage what you can visualize. A good cash flow forecasting system helps the company analyze its existing data to predict future cash flows. So, if there is likely to be a restriction in cash flows, the company will be better prepared. If a surplus is expected, plans can be made in advance to make the best use of it. TallyPrime offers excellent data analysis and financial forecasting tools for reliable cash flow forecasting. 

Supply chain finance: Supply chain finance is also called reverse factoring and uses third parties to fund earlier payments to suppliers. This improved the supplier’s DSO, and the buyers can also plan to pay the amount at a time that is more convenient for them rather than when the invoice is due. 

Dynamic discounting: Companies offer their customers discounts for earlier payments. This flexible price ensures that the buyers add more liquidity to the company quicker and enhance cash flows. Buyers are also happy since they also benefit. 

Flexible funding: A company that has a very flexible funding approach to funding will be able to easily move between supply chain finance and dynamic discounting models as required to keep their working capital management optimal.