The best formula for working capital is current assets minus current liabilities, which measures a company’s ability to meet upcoming financial needs. It can be broken down into smaller chunks, such as outstanding inventory days, outstanding sales days, and outstanding payment days, to improve understanding of a company’s financials.
The best formula for working capital is perhaps the most common, which is current assets minus current liabilities. This formula is common because business owners and managers can use the information in their balance sheets to calculate working capital. Inventors and other outside business stakeholders may also use this formula since the necessary figures are found in a company’s financial statements released for public use. Publicly owned companies must also undergo audits, which are external reviews of the company’s financial information that ensure that the financial statements are accurate and valid.
Current assets include a company’s cash or cash equivalents, short-term marketable securities, accounts receivable, inventory and other items that the company expects to use within the next 12 months. Current liabilities are similar to current assets because they have short-term financial obligations, such as accounts payable, notes payable, and short-term loans that require full payment within the next 12 months. Current assets minus current liabilities is the best formula for working capital as it measures a company’s ability to meet upcoming financial needs.
Another reason this is the best formula for working capital is because it can be broken down into smaller chunks. Business owners and managers can focus on these additional elements to determine which part of working capital lags behind or far ahead of the others. Companies that use this formula to make decisions will often use these additional formulas to improve their understanding of the company’s financials.
Within the best working capital formula – current assets minus current liabilities – business owners and managers can review outstanding inventory days, outstanding sales days, and outstanding payment days. These three elements make up the cash-to-cash cycle, which determines how quickly a business can turn inventory and receivables into cash, which works in tandem with the best working capital formula.
To calculate inventory days sold, owners and managers can divide the ending annual inventory by the ending cost of goods sold for 365 days of the year. Indicates how quickly a business turns inventory into sales, preferably in lower numbers. Sales balance days indicate how long it takes for a business to collect money from account sales. This formula is checking accounts receivable divided by total credit sales times the number of days to collect credits. Again, a lower number is evidence that the company spends less time generating cash from account sales. For the days outstanding formula, it is the overdraft divided by the cost of goods sold by the number of days to pay bills. A higher number may be better as it means companies take longer to pay off commercial creditors. However, taking too long can ruin the credit standing of the company with these companies.
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