how to calculate working capital?

The other day I was asked to evaluate a strategy and provide the pro’s and con’s.  One of the pro’s for the company was that the strategy would significantly improve their working capital.

what is working capital?

Working capital is a fairly standard financial metric that lends to the operating liquidity of the company.  It is calculated as current assets minus current liabilities.  If a company’s current assets are lower than their current liabilities a company is consider to have a working capital deficiency.  In other words, if they liquidated all their current assets they would not be able to pay off their current liabilities.  Not good if you can’t pay the bills.  On the flip side, positive working capital is required in order for a company to be able to continue operations.

how do I improve working capital?

Typically working capital involves the management of inventories, accounts receivables and payables, and cash.  For a software company it really comes down to the last three.  Of course, most people jump to:

we’ll just sell more!

Yes, but that goes to accounts receivables (asset), with a potential offset to deferred revenue (liability) or the subsequent payment (asset) of an outstanding invoice (payable).  Bit o’ the chicken and the egg.  The better answer is to keep selling more but to be more efficient or fiscally prudent with the cash you have.  CASH IS KING!  so by being frugal you build up that cash position.

why should we work towards positive working capital?

Sure, you can keep getting venture financing until you are blue in the face and at the same time giving up more and more of your company.  But, if you want to go the traditional debt avenues (e.g. a line of credit) then the current asset to current liability ratio (essentially another way of saying working capital) is a key metric for lenders.  So, showing an improvement in your working capital, which would involve positive returns on operating income, reinforces your ability to continue operations which would allow you to negotiate more favorable terms from lenders.  And, of course, there is the basic reason: survival.

The most common place you will see working capital articulated is in Note 1 of your financial statements which is the “going concern” note.  This is where you try to convince your readers that you have the ability to meet your financial obligations and the best way to reinforce that sentiment is with the working capital financial metric.

During these economic hard times many of you may be considering getting a loan.  Understanding your working capital position will allow you to speak the same language as the bank - and, unfortunately, will also let you know the primary reason you are being turned down.  Good luck!