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Complete Guide on How to Calculate Working Capital Ratio

Personal Finance
08-11-2023

What is Working Capital?

Working capital finance is the money your business needs for everyday tasks. This is the difference between current liabilities and current assets. You must track this because you should know how much money you need. But, this cost can change at any time. The working capital allows for responding to new opportunities. You can calculate the working capital cycle by using this formula:

Inventory days + receivable days – payable days = working capital cycle in days.

Working Capital Loan: Everything You Need to Know

Not every business has the funds to perform its daily operations. This is why they take a working capital loan. A working capital loan is a loan that any business takes to fulfil its daily tasks.

Remember these loans are not investments. Also, they are not for buying any asset. But this money is only to cover any business’s urgent needs.

These everyday tasks can include debt payments, payroll, and rent. The loans are linked to a business owner’s credit. If they miss payments, this can affect their credit score.

There are many advantages of taking a working capital loan. It allows a business to carry out its daily tasks with ease. Let us have a closer look at them.

• A working capital loan is easy to get. It allows companies to meet their urgent financial needs. The process is simple.
• You receive the amount together. This ensures businesses can carry out their everyday tasks. Also, it boosts the impact of the funding.
• The best part about a working capital loan is that business owners need not give up control of the business.

Why is working Capital Important?

This is one accounting term you hear often. But the working capital is important for the success of your business. Working capital affects many factors of your business. For example, it affects how you pay your employees. In addition, it determines how you plan for long-term growth.

Working capital loans are essential when businesses run out of money to carry out their daily tasks. To ensure the working capital you have is correct, you need to calculate many factors. Some include your future and current needs of the business.

How To Calculate Working Capital?

It is simple to calculate the working capital if you understand the formula. In the formula, you will notice that we subtract current liabilities from current assets.

If you get a positive number, this means you have enough funds to cover daily expenses. But if the number is a negative one, it means your business is not doing great.

Formula:

Working Capital = Current Assets – Current Liabilities

Let us understand the formula better.

What are Current Assets?

Current assets are everything your business owns that you can convert into cash in a year. Examples of these include:

• Prepaid expenses.
• Cash at the bank.
• Short-term investments.
• Outstanding invoices.
• Government bonds.
• Stock.

What are Current Liabilities?

Current liabilities include any debt or bills your business has not paid yet. Examples of these include:

• Short-term loans.
• Rent.
• Wages.
• Bank overdrafts.
• Accounts payable.
• Payroll, sales, and income taxes.
• Outstanding expenses.

Working Capital Ratio Formula

Calculating the working capital ratio helps to understand the ratio of assets to liabilities. In simple terms, it is finding how many times a business can pay its liabilities with current assets.

Here is how you can calculate the working capital ratio.

Working capital ratio = Current assets / Current liabilities

Understanding the Working Capital

• You must know the ratio on paper. This is because two businesses can look similar if you compare their working capital.
• A high ratio means your business has more cash. And this is good news. If the ratio is low, it means the business is not going great.
• Generally, a ratio of less than 1 can mean problems. But a ratio between 1.2 – 2 is safe. Also, if the ratio is high above 2, it means that the business is storing too much cash.
• A company that has good working capital may not make most of its assets. Having positive working capital is great but too much cash doing nothing does not help.
• The business can use idle funds for many purposes. It includes investing in a long-term goal or clearing debt. In addition, the business may also consider buying long-term assets.

The Bottom Line

Working capital gives you an idea to understand your cash flow. This is essential to make sure your business has money for operations.

Taking a capital loan may be helpful in some cases. Your business should always have the funds for its smooth operation. It makes your business reliable and helps with growth.

If you would like to read more, visit the Piramal Finance website. It is your ideal destination for finance-related topics. The blogs on the website will help you understand finances better. Head over to their website to boost your knowledge on everything related to finance.

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