How to Calculate Working Capital Through Your Balance Sheet
Working capital, like cash flow, is something that is constantly changing. Due of this, to calculate your business’s current amount of working capital, you’ll need to review your balance sheet. In this blog post, we’ll explain how to correctly do this so that you can take charge of your business finances.
The Definition of Working Capital
Working capital is the amount of capital your business has that’s uncommitted to paying off short-term liabilities. In other words, working capital is, quite literally, the amount of capital you have to work with.
As you probably know, working capital is inherently valuable to your business. Of course, your business should strive to have as much capital as possible. With more on-hand, your organization will have a greater supply of assets that you can either use, save, or sell.
Calculating Working Capital
Considering its widespread usefulness, the working capital formula might seem surprisingly simple.
Working Capital = Current Assets – Current Liabilities
Both current assets and liabilities can be found directly on your company’s balance sheet. Contrary to your income statement, your balance sheet is a “snapshot” in time, and the numbers are constantly changing. Every time your business changes its amount of currents assets or liabilities, your working capital will be altered in response.
Current assets represent the total amount your business owns in terms of cash and other liquid assets. These include things that will be converted into cash within the next 12 months. Examples of current assets include cash, accounts receivable, inventory, and commercial paper.
The term current liabilities is the amount you currently need to pay to your creditors within the next 12 months. Examples of current liabilities include operating expenses, taxes, and accounts payable.
Your business’ current amount of capital can be changed in multiple ways. If your business increases currents assets or decreases existing liabilities, then your total amount of working capital will increase. If your business decreases current assets or increases current liabilities, then your total level of capital will decrease.
The Usefulness of Working Capital
Many entrepreneurs believe that capital is one of the most useful figures that can be extracted from a balance sheet. Understanding the meaning of working capital can help your company make important decisions such as:
· How to adjust your level of capital use in response to changes in your business cycle. This is especially useful for seasonal retailers.
· If you should apply for a business loan.
· Understand the potential risks and rewards of changing aspects of your business’s operations.
Why Working Capital Matters
There are numerous formulas that you can extract from your business’ balance sheet or income statement. Yet, despite the continuous development of new formulas, capital is something that has maintained its usefulness.
Because capital is derived from current assets and liabilities, this formula is more useful for making short-term decisions. It’s incredibly helpful to businesses that need to make choices they regarding their business’s finances.
Although capital shouldn’t be the only financial ratio that you measure, it’s still beneficial to seemingly every business. Hopefully, now you understand how to calculate positive working capital utilizing a balance sheet!
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Editor’s Note: This post was updated for accuracy and comprehensiveness in August 2020.
Editorial Note: Any opinions, analyses, reviews or recommendations expressed in this article are those of the author's alone, and have not been reviewed, approved, or otherwise endorsed by any of these entities.