Working capital: Different ways to calculate and optimize it

In business, it’s important to have enough cash on hand to keep things running smoothly. That’s where working capital comes in.

Working capital is the money you can access to meet your current financial obligations and keep your business running smoothly. Here we’ll look at what it is and show two different ways to calculate it. We’ll also give you some practical tips that can help you optimize it.

Working capital is a direct measure of your company’s short-term liquidity. It shows your ability to conduct day-to-day operations (things like paying your employees, paying bills, and paying off debt) using your current assets. In short, it represents your company’s relative financial position. 

In accounting terms, working capital is the difference between your company’s current assets and its current liabilities. Your working capital ratio, which is closely related, serves as an indicator of your company’s short-term financial health, since it measures your ability to cover your short-term debts.

There are two main ways to calculate working capital: as a dollar value and as a financial ratio.

1. Add up all your company’s current assets, which are also known as liquid assets. This includes cash and cash equivalents, accounts receivable, inventory you can quickly convert to cash, prepaid expenses and short-term investments such as marketable securities.

   Fixed assets like buildings, equipment, software and other long-term investments are not current assets. Intercompany advances and shareholder loans that are not expected to be paid back should also be excluded from your current assets.  

2. Subtract your current liabilities, which are also known as short-term liabilities. They include accounts payable, accrued expenses, payroll, credit card balances and taxes payable.

The working capital formula is:

Working capital = Current assets – Current liabilities

The result is your working capital in dollars. This number gives you a snapshot of your company’s short-term financial health. It basically tells you whether you have enough money to keep operating smoothly. 

1. Calculate your company’s current assets and current liabilities as explained in steps 1 and 2.

2. Next, instead of subtracting, divide your assets by your liabilities.

This shows your working capital ratio, or current ratio. It gives you a quick view of your company’s short-term financial health.

The working capital ratio formula is:

Working capital ratio = Current assets ÷ Current liabilities

Calculating your ratio gives you a clearer picture of your company’s short-term financial health and your ability to cover your short-term debts: 

Less than 1 : It might be hard for you to meet your immediate financial obligations, because your current liabilities are more than your assets, meaning you have negative working capital.

Equal to 1 : You’re just able to cover your short-term obligations. 

Greater than 1 : This is a good sign. It means your current assets are more than your liabilities, so you have positive working capital.

Greater than 2 : A lot of your money is probably tied up in things like inventory or excess cash, which means it’s not available to be reinvested.

Ideally, you want your current ratio to be at least 1.5, and ideally closer to 2, to give you some breathing room.   

Your company’s needs depend on its situation and specific circumstances. Here’s a breakdown of the different types of working capital you may require:

This is the minimum cash you need to keep your business operating smoothly, even when things are slow. Think of it as the financial baseline you need to cover your fixed costs and remain operational.

Some businesses live and die with the seasons (think of holiday shopping for retailers). This means they typically require extra working capital on a temporary basis to cover additional salaries and merchandise when customer demand is high.

This refers to an exceptional or one-time need, triggered by something specific like an economic slowdown, a massive advertising campaign or a short-term investment to seize a new opportunity.

Your working capital and working capital ratio are indicators of your company’s financial health. At the end of the day, they show how well your company is managing its money. If the numbers line up with industry standards (and your company’s own needs), it’s usually a clear sign that your company’s in good shape.

Having enough working capital basically means your business has the cash and resources it needs to keep the lights on and even fuel growth. Good cash flow management usually means that things are being managed well overall, and the company has some financial breathing room.

While it’s typically not a great idea to use your working capital to pay for big long-term purchases, it can be used to cover something like a down payment. Leveraging it in this way means you’ll have to borrow less, which also means you’ll pay less interest. 

Having extra cash on hand may also give you the freedom to seize unexpected opportunities, like buying inventory from a partner holding a fire sale, for example. 

Some factors that can affect your business are outside of your control, like interest rates and political decisions. But having enough working capital gives you a safety net that can help your business weather tough times.

Even with careful financial management, mistakes can still happen. Here are some common missteps to watch out for, along with practical tips to help you steer clear of them.

If you have too much inventory or other assets, your working capital might look strong on paper. But in reality, you’ve locked up cash that you could otherwise invest or use to grow your business, which reduces your financial flexibility.

It’s risky to assume that you can just convert your assets to cash with a snap of your fingers. If your inventory is out of date, for example, your working capital might look stronger than it really is, because its resale value is often much lower than what’s on the books.

It’s important to remember that these are two different things. Your cash flow is all about money coming in and going out. And your cash flow can affect your working capital, for better or for worse. 

That’s why it’s a good idea to check your balance sheet and cash flow statements every month. That way you’ll see how your money is moving around and the impact it can have on your short-term finances. 

Your working capital is really meant to cover short-term costs like bills and everyday expenses. For bigger expenditures, like a new truck or major renos, long-term financing is a better choice. That way, your cash is available to grow your business, and you can use the extra money you make to pay off your loan.

As a small business owner, you may be tempted to make a big withdrawal to pay yourself dividends or a bonus after a good year. But without a solid plan, these sorts of withdrawals can slow down future growth. The solution? Cash forecasting and a well-structured annual budget can help guide your decisions and make sure you have enough liquid assets to finance future projects.

Now that you know about some of the common mistakes to avoid, you may want to consider some practical ways to optimize your cash flow and working capital. Even small tweaks can help free up valuable cash and improve your company’s financial health.

Unlike cash, inventory keeps your money tied up money until it’s sold. Not only that, but it also costs money to store and insure it. That’s why it’s so important to maintain a healthy inventory—not too big, and not too small. Just enough to meet demand without straining your resources. 

Some businesses take a just-in-time approach to inventory management, while others rely on regular tracking of inventory turnover to fine-tune their ordering process. There’s a solution out there that’s right for you!

It can be helpful to try aligning the timing of your supplier payments with the payments you receive from customers. If you can’t line them up, the next best thing is to try to close the gap as much as you can. This can improve your cash flow management and working capital cycle by using customer payments to pay off suppliers.

One strategy is to negotiate longer payment terms with your service providers. It also helps to use direct deposit instead of cheques so you don’t have to pay until the due date. Learn more about Desjardins’s accounts payable tools or check with your financial institution to find out what they offer. 

As far as your customers go, you could offer an early payment discount or accept payment by credit card, despite the fees. You may also want to look into other accounts receivable tools, such as preauthorized debits (PADs), to simplify how you collect payments from your customers. 

It’s better to anticipate your needs than to find yourself short at crunch time. Monthly cash flow projections can help you estimate your inflows and outflows and the effect they have on your working capital. 

A lot of different accounting software platforms offer this feature, but you can use something as simple as a custom spreadsheet designed for your business.

Even with careful budgeting and solid financial planning, sometimes you might need a little extra cash to cover day-to-day operations. When that happens, short-term financing solutions can help.

A business line of credit is kind of like a financial safety net. It gives you fast access to a certain amount of cash, typically based on the value of your accounts receivable and/or inventory. You only pay the required monthly interest on what you actually use, according to the terms of your loan contract, and once your cash flow picks up, you can pay it back. It’s a flexible way to handle short-term gaps between money in and money out.

Need cash fast? With factoring, you can sell some of your outstanding invoices to your financial institution or a private factor at a discount, which gives you immediate access to cash. It can be a good option for start-ups that need to keep up their momentum and for exporters who want to hedge the risk of not getting paid by new international customers.

Bridge financing is a type of short-term loan that gives your business a cash injection while you’re waiting for money you know is coming in, like a grant or a tax credit. The repayment terms are usually agreed on up front, so there won’t be any surprises. Bridge financing can be a practical way to keep your business rolling and make future-facing decisions without having to put projects on hold.

Managing your working capital well is one of the smartest things you can do for your business. If you avoid common mistakes, make thoughtful adjustments and use short-term financing tools when it makes sense, your business may be agile enough to seize opportunities as they arise. Build good habits and let your money help turn great ideas into real results.

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