Working capital is one of the most important measures in finance, representing the amount of money you have available to support your ongoing business operations. Working capital can be expressed in different ways depending on what type of business you’re running, but the calculation itself is simple, making it easy to use this essential metric as an indicator of your company’s financial health and stability. Here’s how to calculate working capital in four simple steps.
Step 1 – Understand the True Cost of Goods Sold
The first step in calculating your working capital is understanding the true cost of goods sold (COGS). This includes all the direct costs associated with producing your product or service, including materials, labor, and shipping. To get an accurate picture of your COGS, you’ll need to track these costs carefully over time.
Your COGS is important because it directly affects your working capital. The lower your COGS, the less cash you need on hand and on account to run your business day-to-day. To find out how much you’ll need, you first need to subtract your current COGS from what you expect sales will be for a particular month or quarter. For example, if sales are expected to total $500,000 but your company currently has a COGS of $400,000 per month, then you’ll need an additional $100,000 per month of working capital. You can track these numbers over time and use that data to project future needs.
Step 2 – Add Back Other Non-Cash Expenses
Other non-cash expenses, such as depreciation and amortization, must be added back into the working capital calculation. This is because these expenses are used to fund future operations and are not paid out in cash. Depreciation is a non-cash expense that represents the wear and tear on assets, while amortization is a non-cash expense that represents the value of intangible assets, such as patents or copyrights.
- Add up your current assets. This includes cash on hand, accounts receivable, inventory, and other short-term assets.
- Subtract your current liabilities. This includes accounts payable, taxes payable, wages payable, and other short-term debts.
Calculate your working capital by subtracting your current liabilities from your current assets. The resulting number is expressed as a percentage of your total assets. This percentage helps you identify whether you have enough working capital to support planned future operations and should be used to compare against industry benchmarks. (A lower number can indicate trouble if you are falling behind on short-term obligations.)
Step 3 – Subtract Current Asset Balances
The working capital calculation begins with current assets, which are assets that can be quickly converted into cash. To find your current assets, you’ll need to review your balance sheet. Once you have your current asset balances, you’ll need to subtract any outstanding balances for employees or other funds that you may owe. This will give you your working capital.
Next, you’ll need to review your income statement, which provides key financial data about your business for a specific period of time. In particular, you’ll want to find your current assets and subtract any outstanding current liabilities from that total. Current liabilities are debts that come due within 12 months and can include bills like payroll expenses, vendor invoices or employee taxes that are past due. Your total remaining balance will be called your working capital.
If you end up with a negative working capital, your business isn’t well-positioned for growth and expansion. To determine how much additional funds you’ll need, take your total liabilities and subtract them from your equity. Equity is calculated by adding up all of your assets and then subtracting any debt or other liabilities. The resulting figure is what you have available to support growth. Your current asset balance can also help you gauge whether it’s worth it to borrow money or raise additional funds if your working capital is negative. If you have only a small amount of outstanding debt, raising new funding may be unnecessary, especially if it will force you into an unprofitable business model with high overhead costs for financial obligations like interest payments on loans and other fees associated with raising financing.
Step 4 – Calculate the Cash Shortfall
In order to calculate the cash shortfall, you’ll need to first estimate the company’s monthly cash needs. To do this, add up the cost of all inventory that will be purchased, the cost of any labor that will be paid, and the company’s overhead expenses. Then, subtract this total from the company’s monthly revenue. This number is the cash shortfall.
One way to ensure that your company has enough cash on hand is to make sure you’re never running a cash shortfall. A cash shortfall means that your business isn’t bringing in enough money during a given month, so it can no longer cover its expenses and payroll. The best way to calculate a potential cash shortfall is by tracking your business’s revenues and expenses each month. While there are some costs that can be difficult or impossible to anticipate, most businesses know what their biggest expense categories will be each month. Having an understanding of these major cost centers will help you determine whether you’ll need additional capital before running out of funds.
Once you have a good idea of your business’s major expenses, you’ll need to estimate each category’s monthly revenue. For example, if you know that a large percentage of your business’ revenue will come from selling goods through e-commerce platforms, add up what you paid for goods and divide it by your number of sales. You can do a similar calculation for labor costs. One thing to keep in mind is that calculating your company’s working capital may not necessarily be an exact science. For example, when estimating your inventory needs over the next month, you may be off slightly one way or another and still come out ahead at month’s end.