Working capital is cash and assets that are easily cashable to fund the company's day-to-day operations. With working capital information, you can manage your business well and make the right investment decisions. By calculating working capital, you can also determine whether a company is able to pay its short-term obligations and in how long. Companies that lack or do not have working capital will have problems in the future. Calculation of working capital is very useful to assess whether business activities are efficient enough in utilizing company resources. The formula for calculating working capital is:
Working capital = current assets – current liabilities.
Step
Part 1 of 2: Calculating Working Capital
Step 1. Calculate the amount of current assets
Current assets are company assets that can be converted into cash within one year. These assets consist of cash and other short-term accounts. Accounts included in current assets include accounts receivable, prepaid expenses, and inventories.
- This information is usually presented in the company's balance sheet with the description "current assets".
- If the balance sheet does not include the amount of current assets, read it line by line. Add up all the accounts that fit the definition of current assets to find the figure. You can add up “trade receivable”, “inventory”, “cash”, and other accounts that fall into the cash category.
Step 2. Calculate the amount of current debt
Current liabilities are liabilities that will mature within one year. Accounts included in current liabilities include trade payables, accrued payables, and notes payable.
The balance sheet should present the amount of current debt. If there are none, you can add up the current accounts payable in the balance sheet, for example “trade payable”, “tax payable”, and “short-term debt”
Step 3. Calculate the amount of working capital
This calculation is carried out with the usual subtraction. Subtract current assets from current liabilities.
- For example, a company has current assets of $50,000 and current liabilities of $24,000,000. According to the above formula, this company has a working capital of Rp. 26,000,000 which can be used to pay off current debts and there is still more funds than current assets to pay for other needs. The excess funds can be used to finance operational activities, pay long-term debt, or be distributed to shareholders.
- If current liabilities are greater than current assets, this means that there is a working capital deficit. A working capital deficit can be an indication that the company is insolvent and can be overcome by increasing long-term debt. This condition indicates a problem in the company and is not the right choice to invest.
- For example, a company has current assets of Rp. 100,000,000 and current liabilities of Rp. 120,000,000, resulting in a working capital deficit of Rp. 20,000,000. In other words, the company will not be able to pay off its short-term debt and will have to sell its fixed assets for Rp. 20,000,000 or look for other sources of funds.
- In order to continue operating while paying off debt, the company can apply for debt restructuring if it is threatened with insolvency.
Part 2 of 2: Understanding and Managing Working Capital
Step 1. Calculate the current ratio
To find out more about the company's condition, analysts use an indicator of financial health called the “current ratio”. The current ratio is calculated using the same figures in the working capital calculation described earlier, but the result is a ratio, not in rupiah.
- A ratio is a comparison between two numbers. Calculating the ratio is done by ordinary division.
- To calculate the current ratio, divide current assets by current liabilities. Current ratio = current assets: current liabilities.
- Using the same example, the company's current ratio is 50,000,000: 24,000,000 = 2.08. A ratio of 2.08 indicates that the company's current assets are 2.08 times greater than its current liabilities.
Step 2. Know what ratio means
The current ratio is used to evaluate the company's ability to pay off current debt. In short, this ratio describes how much the company's ability to pay its bills. The current ratio is usually used to compare the financial condition of a company with other companies or with the industry.
- The most ideal current ratio is 2.0. Companies with a small current ratio or below 2.0 can face a high risk of insolvency. On the other hand, a current ratio of more than 2.0 indicates that management is too careful and less than optimal in taking advantage of business opportunities.
- With the same example, a current ratio of 2.08 indicates a healthy financial condition of the company. In other words, current assets can fund current liabilities for two years assuming the amount of debt remains the same.
- The current ratio that is considered good varies by industry. Some capital-intensive industries require more borrowed funds to finance their activities. Manufacturing companies usually have high current ratios.
Step 3. Perform working capital management
A business manager must know all aspects that affect working capital so that he can manage it properly, such as inventory, accounts receivable, and accounts payable. He must also be able to assess the profitability and risks arising from a shortage or excess of working capital.
- For example, a company that lacks working capital will not be able to pay off short-term debt, while too much working capital can also be a problem. Companies that have a lot of working capital can invest to improve long-term productivity. For example, surplus working capital can be invested in new production facilities or to expand the marketing network by opening new shops. This investment can increase your income in the future.
- If the working capital ratio is too high or too low, consider the following suggestions to improve it.
Tips
- Try to manage bills well so that all customers pay on time. If there is a problem with arrears, offer a discount for those who pay early.
- Pay off short-term debt on the due date.
- Do not buy fixed assets (eg a new factory or new building) with short-term debt because it will be very difficult to convert fixed assets into cash so that it affects working capital.
- Maintain the ideal amount of inventory so there is no shortage or excess. Many manufacturers manage inventory based on the "just in time" (JIT) method because it is more efficient. With this method, goods are produced to order and directly distributed to distributors/customers so as to reduce storage space and risk of damage.
