Calculating working capital gives companies a quick assessment of how liquid and solvent they are. The figure is relevant for investments and financing – not only for established companies but also for startups.
Solvency, liquidity, cash flow, profitability: for companies, these are essential metrics helping them to check their financial health. It is the basis on which they drive growth and make investment decisions. An important indicator of this is working capital and the working capital ratio.
In this article, we look at what working capital is and what it means. We also analyze how companies can use their working capital to make financing decisions and position themselves for negotiations with investors.
Definition: what is working capital?
Working capital is a balance sheet figure. It is also known as net current assets. It provides companies with an initial sign of their liquidity and solvency.
Working capital is calculated from the difference between current assets and current liabilities.
Two accounting philosophies meet
The term "working capital" originates from the Anglo-Saxon accounting world. It has found its way into the balance sheet valuation of European companies in recent years. This was due to the different accounting approaches.
Corporate accounting in Europe was rather conservative for a long time. Anglo-Saxon companies are generally more proactive. Their focus tends to be on the attractive presentation of the company to investors and shareholders. Solvency and liquidity play a key role in this regard.
For a long time, only lenders (banks and funds) focussed on working capital. However, companies are recognizing the advantages of looking at working capital.
The meaning of working capital
Working capital tells us something about how liquid a company is. It provides initial answers to the following questions:
- Can I meet my short-term liabilities from my funds?
- How well prepared is my company for times of economic crisis?
- Can I handle a drop in revenue well or not?
- If my business is subject to seasonal fluctuations, can I compensate for them?
- Am I in a position to finance further growth?
- How well positioned is my company to receive fresh external capital?
- How much capital is tied up in the company?
Consequences of positive working capital
Positive working capital helps a company to service its short-term liabilities from its resources. It can react to short-term costs and drive expansion and growth - either alone or with the help of third-party financing. Depending on the extent, companies can bridge even difficult economic times.
Consequences of negative working capital
If working capital is negative, the company needs external funds (equity or debt capital) to service its short-term liabilities. This can be an initial indicator that there are structural problems. Liquidity problems and payment difficulties may arise in the future.
Working capital that is too high
However, some companies want to avoid having too much working capital. It is because it indicates that too many funds are tied up, and profitability is suffering as a result.
In that case, idle capital cannot be used for investments and growth projects. It does not add value in the long term. A sign of too much working capital is excessive inventories or large amounts in bank accounts.
Working capital assessment depends on the industry
A working capital analysis and its implications must consider the industry and market in which a company operates. If a business is subject to seasonal fluctuations (e.g., construction or gardening and landscaping), it is common for working capital to fluctuate significantly.
Such companies need to prepare appropriate measures: in months when revenues are high, they need to build up enough working capital to finance the months when revenues are low. Why? During these phases, companies still have to pay rent and salaries.
Distinguishing between working capital and liquidity
"Working capital" and "liquidity" should not be used synonymously. Although there is a connection, working capital should rather be seen as a reference point for evaluating a company's potential liquidity. It is not an exact measure.
Formula and calculation of working capital
The formula for calculating working capital is current assets – current liabilities.
It describes which parts of current assets can generate short-term revenue and are not debt-financed. Generally, these are inventories and receivables.
Working capital ratio
To calculate their working capital ratio (liquidity ratio), companies must set their current assets in relation to current liabilities.
The formula is current assets / current liabilities.
A ratio of more than 1 indicates that current assets exceed current liabilities. Usually, companies want to achieve that.
Current assets include:
- Inventories, like raw materials, supplies, auxiliary materials, finished and unfinished goods, and merchandise.
- Accounts receivables that are converted into revenue within 12 months or one balance sheet year.
- Securities
- Cash and cash equivalents from bank balances and open checks.
Current liabilities include:
- Short-term loans from a bank (< 12 months)
- Overdraft facility
In general, current liabilities include all liabilities with a remaining term of one year or less. They must be paid within this period.
Example calculation working capital
- The balance sheet total is €2.2 million.
- The current assets total €800,000.
- The current liabilities amount to €600,00.
The example calculation shows a working capital of €200,000 and a working capital ratio of 1.3 or 130%. Both key figures are calculated as follows:
Working capital
€800,000 Current assets
– €600,000 Current liabilities
= €200,000 Working Capital
Working capital ratio
€800,000 current assets / €600,000 current liabilities = 1.33
The company has positive working capital, which indicates good liquidity.
Quick and easy calculation
Calculating working capital is simple compared to other balance sheet figures. It gives companies a quick initial indication of how financially healthy they are.
However, working capital only sheds light on the short-term financial situation. Long-term liabilities are not taken into account. They need further calculations. These include, for example, calculating the equity and debt ratio or the debt-equity ratio.
Net working capital
Net working capital identifies which part of a company's assets is part of short-term revenue generation and is not financed by debt.
The formula for calculating net working capital is current assets – current liabilities – cash and cash equivalents.
Working capital management
Now we know what working capital is, how it is calculated, and what influences the working capital ratio. But what if a company wants to improve its working capital?
Then working capital management (WCM) can help.
It describes how companies can influence their working capital. WCM relates to securing and optimizing liquidity. It enables companies to cover their short-term costs and liabilities.
Working capital management strengthens financial stability
Companies strengthen their financial stability through active working capital management. It can lead to higher profitability and company valuation.
Efficient WCM also expands the scope for potential investments and provides an initial indication of how extensive these need to be. Startups in particular can use these measures to make themselves more attractive to investors in preparation for financing rounds.
Three factors have a significant influence on working capital: receivables, liabilities, and inventories.
Factors that influence working capital
Receivables
Many outstanding receivables and long payment terms affect working capital. Companies should use working capital management to ensure a smooth collection of receivables to avoid long payment terms. Both affect their liquidity.
If a company has to wait a long time for the payment of its invoices, it provides upfront payments. This puts a strain on its cash flow as the funds are tied up elsewhere. This restricts the financial scope for action. One solution to this can be working capital financing using factoring.
A company should consider the following points when dealing with receivables:
- Short payment terms I: The longer the customer's payment terms, the higher the level of receivables and the greater the risk of default on a receivable.
- Short payment terms II: If you receive your money quickly, you directly improve your cash flow.
- Comprehensive assessment of creditworthiness: To keep payment defaults to a minimum, customers should undergo detailed due diligence.
- Efficient collection system: This helps to reduce the amount of losses on receivables.
Use Days Sales Outstanding (DSO) as a metric
One key figure to receivables is Days Sales Outstanding (DSO). It measures how long a company needs to collect receivables from outstanding invoices. A high DSO can state problems in receivables management. It offer a starting point for improvements.
Liabilities
As current liabilities directly impact working capital, companies should aim to keep them as low as possible. It can also be an expression of high margins and profits.
However, companies should not just start converting short-term liabilities into long-term liabilities. This is because long-term interest obligations affect a company's liquidity – especially in an environment of rising interest rates.
To improve working capital management, discounts or other reductions positively influence liabilities.
Using Days Payable Outstanding (DPO) as a metric
When it comes to liabilities, companies can use Days Payable Outstanding (DPO). It indicates how long it takes a company to pay third parties. A high value indicates a delay in payments.
A quick repayment leads to a better cash flow. If a company is too pushy in collecting its payable outstanding, it can lead to difficult relationships with suppliers or service providers. This can be a disadvantage in negotiations.
Inventories
For traditional retail companies, e-commerce, or manufacturing companies, inventory management is a way of improving their working capital.
Excessive inventory levels tie up a lot of capital. Stock levels that are too low can lead to delivery bottlenecks and delays.
Companies want to avoid both scenarios. It is important to build up and manage an inventory that is stable in value and able to meet ongoing customer demand. The evaluation of the annual inventory is an indicator of an efficient warehouse management.
Using Days Inventory Outstanding (DIO) as a metric
One key figure for this is Days Inventory Outstanding (DIO). It describes how many days it takes on average for warehouse goods to be sold. It shows how efficiently a company can convert its stock into sales – depending on the sales cycle.
Conclusion: working capital in financing a company
Working capital can play a role in debt financing. With working capital financing, companies receive short-term fresh liquidity to settle liabilities, make investments, or improve their cash flow. This is particularly interesting for fast-growing companies.
When financing working capital, companies can access a variety of instruments. Usually, those are tied to debt capital. Depending on the industry and business model, companies can consider the following forms:
- Utilization of the credit line
- Loans on receivables
- Factoring
- Lending on inventories
- Alternative financing models, such as revenue-based financing or recurring revenue financing
Companies have increasingly turned their attention to working capital in recent years. They have also found new ways of debt financing as a result.
