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 business stakeholders can also use this formula since the figures needed are found on a company’s financial statements released for public use. Publicly held companies must also undergo audits, which are external reviews of the company’s financial information that ensures 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 a company expects to use within the following 12 months. Current liabilities are similar to current assets because short-term financial obligations, such as accounts payable, notes payable, and short-term loans that require full payment within the following 12 months. Current assets less current liabilities is the best formula for working capital since 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 pieces. Business owners and managers can focus on these additional items to determine which part of the working capital is lagging or well ahead of the others. Companies that use this formula for making decisions will often use these additional formulas to enhance their understanding of the company’s financial figures.
Inside the best formula for working capital — current assets less current liabilities — business owners and managers can review the days inventory outstanding, days sales outstanding, and the days payable outstanding. These three items make up the cash conversion cycle, which determines how quickly a company can turn inventory and accounts receivable into cash, which works in tandem with the best formula for working capital.
To calculate the days sales of inventory, owners and managers can divide ending annual inventory by ending cost of goods sold times 365 days in a year. This indicates how quickly a company turns inventory into sales, with lower numbers preferable. The days sales outstanding indicates how long it takes a company to collect cash from account sales. This formula is current accounts receivable divided by total credit sales times the number of days to collect receivables. Again, a lower number is evidence that the company takes less time to generate cash from account sales. For the days payable outstanding formula, it is current accounts payable divided by cost of sales times the number of days to pay bills. A higher number may be better since it means companies take a longer time to pay trade creditors. However, taking too long can ruin the company’s credit status with these companies.
