The best formula for working capital is current assets minus current liabilities, which measures a company’s ability to meet upcoming financial needs. Business owners can break down this formula into smaller pieces to improve their understanding of the company’s financial numbers, including days inventory outstanding, days sales pending, and days pending payment.
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 found on their balance sheets to calculate working capital. Inventors and other outside commercial stakeholders can also use this formula, since the necessary figures are found in a company’s financial statements published for public use. Publicly traded companies are also required to undergo audits, which are external reviews of the company’s financial information to 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 a company expects to use within the next 12 months. Current liabilities are similar to current assets in that they are short-term financial obligations, such as accounts payable, notes, and short-term loans that require payment in full within 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 why this is the best formula for working capital is because it can be broken down into smaller pieces. Business owners and managers can focus on these additional items to determine which part of working capital is lagging behind or far ahead of others. Companies that use this formula to make decisions often use these additional formulas to improve their understanding of the company’s financial numbers.
Within the best formula for working capital (current assets minus current liabilities), business owners and managers can review days inventory outstanding, days sales pending, and days pending payment. These three elements make up the cash conversion cycle, which determines how quickly a company can convert inventory and accounts receivable into cash, which works in conjunction with the best formula for working capital.
To calculate inventory days sold, owners and managers can divide ending annual inventory by dividing ending cost of goods sold by 365 days in a year. This indicates how quickly a company turns inventory into sales, preferring lower numbers. Days sales pending indicate how long it takes a company to collect cash from account sales. This formula is current accounts receivable divided by total credit sales multiplied by the number of days to collect accounts receivable. Again, a lower number is evidence that it takes less time for the company to generate cash from account sales. For the days pending payment formula, this is current accounts payable divided by cost of goods sold multiplied by the number of days to pay invoices. A higher number may be better as it means companies take longer to pay trade creditors. However, taking too long can ruin a company’s credit standing with these companies.
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