Working Capital: What It Is, How To Calculate
Working capital refers to the amount of money a company has available to fund its day-to-day operations.
It is calculated as the difference between a company’s current assets, which include cash, accounts receivable, inventory, and other short-term assets, and its current liabilities, which include accounts payable, short-term debt, and other obligations that are due within one year.
Why do we use working capital?
Working capital is important because it is needed to pay for a company’s ongoing expenses, such as salaries, rent, inventory, and other costs. If a company has insufficient working capital, it may struggle to meet these obligations, which can lead to financial difficulties, such as missed payments or even bankruptcy.
Working capital is also an important measure of a company’s liquidity, or its ability to meet its short-term obligations. A company with strong working capital is better positioned to take advantage of growth opportunities, invest in new projects or initiatives, and weather economic downturns or other challenges.
It’s important to note that working capital requirements can vary depending on the industry and business model of a company. For example, a company with high inventory turnover may require more working capital to maintain sufficient stock levels, while a service-based business with lower overhead costs may require less.
Overall, working capital is a key financial metric that reflects a company’s ability to operate efficiently and effectively in the short term, and is an important consideration for investors, lenders, and other stakeholders.
Let’s now see 2 examples of how we calculate working capital for 2 different businesses: a restaurant and a retail store.
Calculating Working Capital for a Restaurant
For a restaurant, working capital is calculated by subtracting current liabilities from current assets. Here’s an example:
Current Assets:
- Cash on hand: $5,000
- Inventory (food, beverages, supplies): $3,000
- Accounts receivable: $0
Total Current Assets: $8,000
Current Liabilities:
- Accounts payable (food and beverage vendors): $2,000
- Short-term debt (e.g. credit card balance): $1,000
- Payroll liabilities: $1,500
Total Current Liabilities: $4,500
Working Capital = Total Current Assets – Total Current Liabilities Working Capital
Working Capital = $8,000 – $4,500 = $3,500
In this example, the restaurant has $3,500 in working capital available to cover its day-to-day expenses.
Calculating Working Capital for a Retail Store
For a retail store, working capital is calculated in the same way as for a restaurant, by subtracting current liabilities from current assets. Here’s an example:
Current Assets:
- Cash on hand: $10,000
- Inventory (merchandise): $20,000
- Accounts receivable: $0
Total Current Assets: $30,000
Current Liabilities:
- Accounts payable (vendors): $8,000
- Short-term debt (e.g. credit card balance): $2,000
- Payroll liabilities: $3,000
Total Current Liabilities: $13,000
Working Capital = Total Current Assets – Total Current Liabilities Working Capital
Working Capital = $30,000 – $13,000 = $17,000
In this example, the retail store has $17,000 in working capital available to cover its day-to-day expenses.
