Working Capital Formula: What It Is and How To Calculate It

Working capital is a financial metric that represents a company’s ability to cover its short-term operational expenses and meet its current liabilities. It indicates the liquidity and financial health of a business. The working capital formula is straightforward and helps assess whether a company has enough short-term assets (like cash, accounts receivable) to cover its short-term liabilities (like accounts payable, short-term debt) over a specific period, typically a year.

The formula to calculate working capital is:

Working Capital = Current Assets – Current Liabilities

Here’s what each component means:

  1. Current Assets: These are assets that are expected to be converted into cash or used up within one year. Common examples include:

    • Cash
    • Accounts Receivable (money owed to the company by customers)
    • Inventory (goods ready for sale)
    • Short-term investments
    • Prepaid expenses (e.g., insurance prepaid for the next year)

  2. Current Liabilities: These are obligations or debts that a company must pay within one year. Common examples include:

    • Accounts Payable (money the company owes to suppliers)
    • Short-term loans or lines of credit
    • Accrued expenses (e.g., wages and taxes owed but not yet paid)
    • Interest payable (short-term interest on loans)

Once you have these values, you can plug them into the formula to calculate your working capital. The resulting figure can be positive, negative, or zero:

  • Positive Working Capital: If the result is positive, it indicates that the company has more current assets than current liabilities. This is generally a sign of good financial health, as it means the company can meet its short-term obligations and has some financial flexibility.

  • Negative Working Capital: If the result is negative, it means the company’s current liabilities exceed its current assets. While this might be a temporary situation for some businesses, it can be a sign of financial distress and may require immediate attention to avoid liquidity problems.

  • Zero Working Capital: If the result is zero, it means the company’s current assets are exactly equal to its current liabilities. While this doesn’t necessarily indicate financial distress, it suggests that the company has minimal financial cushion for unexpected expenses or changes in the business environment.

Working capital management is crucial for businesses to ensure they can cover their short-term financial obligations and operate smoothly. A positive working capital balance is generally desirable, but it’s essential to consider the specific industry and business circumstances when evaluating working capital levels. It’s also important to track working capital regularly and make adjustments as needed to maintain financial stability.