Calculate How Much Working Capital Is Needed to Run Your Business Smoothly

Businesses often struggle between balancing too little & too much cash when it comes to working capital. Check out the ways to calculate working capital here!

25 Jul,2022 15:00 IST 7 views
Calculate How Much Working Capital Is Needed to Run Your Business Smoothly

Working capital measures a company’s ability to pay current liabilities with its assets. It provides an insight into the business short-term financial health, ability to pay off debts within a year, and operational efficiency. If a company lacks sufficient working capital, it will incur losses and have difficulty staying afloat. Learn how to determine your business working capital requirement in this article.

Factors Affecting Working Capital

1. Current Assets

A company can convert its current assets into cash within one year or one business cycle, whichever comes first. They exclude long-term or illiquid investments, such as hedge funds, real estate, and collectables.

Examples of current assets include highly liquid marketable securities such as stocks, mutual funds, bonds, and exchange-traded funds (ETFs); checking and savings accounts; money market accounts; cash and cash equivalents, inventory, accounts receivable, and other shorter-term prepaid expenses.

2. Current Liabilities

A company's current liabilities are all debts and expenses to pay within one year or one business cycle. Current liabilities include capital leases due within one year, dividends payable, and long-term debt that is now due.

Examples of liabilities include utilities, rent, materials, and supplies; accrued liabilities; accounts payable; interest payments on debt; and income taxes accrued.

How To Calculate Working Capital

Although there are different ways to calculate your working capital, most companies prefer to express it in terms of net working capital (NWC). You can calculate your net working capital by subtracting the current liabilities from the existing assets of your business.

Net Working Capital = Current Assets — Current Liabilities

Work capital ratios are also a quick way to assess the company’s financial health.

Divide current assets by current liabilities to calculate the current ratio. A ratio above 1 indicates that current assets exceed current liabilities. An increasing ratio generally indicates that a company can pay its short-term expenses.

Working Capital Ratio = Current Assets ÷ Current Liabilities

Working Capital Indications

In an effective working capital management system, current assets will exceed current liabilities.

• A company’s positive net working capital indicates that it can meet your short-term business needs.
• A nil net working capital indicates that your company has just enough money to meet its short-term obligations.
• A negative net working capital implies that it will need more deficit to meet its current obligations.

Similarly, working capital ratios in the range of 1.2 to 2 are considered healthy for a business.

Working Capital Example

Assume your company has the following assets and liabilities:

Current Asset

Amount (Rs.)

Current Liability

Amount (Rs.)

Debtors

Rs. 1.5 lakh

Creditors

Rs. 3 lakh

Cash

Rs. 25,000

Outstanding expenses

Rs. 25,000

Raw materials

Rs. 15,000

 

 

Inventory

Rs. 6,000

 

 

Obsolete stock

Rs. 25,000

 

 

Prepaid expenses

Rs. 2,000

 

 

Total

2.23 lakh

Total

3.25 lakh

Based on the information above, working capital = 2.23 lakh - 3.25 lakh = 1.02 lakh

With a negative net working capital, your business may have difficulty running day-to-day operations and miss out on lucrative business opportunities. In such cases, finance the deficit and develop a sound working capital management policy to keep your business run smoothly. You can accomplish that by cutting down on your business expenses, boosting sales, or getting a loan.

Get A Business Loan With IIFL Finance

With a working capital loan from IIFL Finance, your business can meet any financial need. We help you grow your business more comfortably with low EMIs and flexible repayment terms.

If you are taking a business loan, you must determine your EMI amount. Using the business loan EMI calculator, you can also calculate your EMI and choose the most suitable product. Get help from our business loan calculator now!

Frequently Asked Questions

Q1. How much working capital does your business need?
Ans. The current ratio can determine whether a firm has enough working capital. Generally, a firm should aim for a ratio of 2. However, different industries or businesses may have varying ratios.

Q2. Does Working Capital Change?
Ans. Working capital changes with time. It's because a company’s current liabilities and current assets change over 12 months.

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