Working capital is the difference between your current liabilities and your current assets. It’s important to have enough working capital.
Working capital is a measure of the liquidity of your company, in other words whether you have enough cash to cover what you owe to suppliers, banks, the tax authorities, and so on.
Having a positive working capital means you’re able to pay what you owe. This means that your company has good short-term financial health.
Current assets and current liabilities
Current assets are short-term resources that are used to cover your day-to-day costs or will be converted to cash within a year. Current assets include:
- Cash
- Raw materials that you’ve bought in order to produce goods
- Inventory
- Accounts receivable, which is all the money that your clients owe you
Current liabilities are liabilities that are due within a year. A liability is something you owe, while an asset is something that you own or are owed. Current assets include:
- Wages and labor costs
- Utilities
- Tax
- Other debts that are due within a year
How to calculate working capital
To calculate working capital, you look at your balance sheet, which is a financial statement that shows everything your business owes and is owed. From there you take all your current assets and subtract your current liabilities. The number you’re left with is your working capital.
How high a working capital you should aim for depends on what industry you’re operating in, the size of your company, how much of a risk you take in your business, and how likely it is that you’ll have costly unforeseen expenses.
For example, if you have expensive machinery that’s liable to break and halt your entire production, you might want to budget with a higher working capital. The same goes for if it takes you a long time to procure goods, since your turnover is slower. On the other hand, if you run an online store with many sales per day, you’re comfortably able to generate more working capital quickly, and might need a lower reserve.