How to Perform a Working Capital Analysis

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Last Updated May 13, 2024

Your working capital is one of the most important measurements of your business’s financial health. As such, understanding how to calculate working capital and analyze what it means for your company’s financial performance is essential.

By regularly performing a working capital analysis, you will have a clear understanding of where your company stands financially, as well as what needs to be done to ensure its long-term stability. Here’s what you need to know about performing a working capital analysis and using it to guide your business.

What Does a Working Capital Analysis Show?

Your business’s net working capital is the difference between your current assets and current liabilities. It’s an important measure of your company’s liquidity—or its ability to cover its short-term liabilities—while also having additional funding left over to invest in growth.

A working capital analysis gives you both an overview of how much working capital your business currently has, as well as a deeper dive into the specifics of its current assets and liabilities. Performing a working capital analysis allows your business to measure these key pieces of financial information.

Objectives of a Working Capital Analysis: Why Is It Important?

A working capital analysis tells you how much working capital and liquidity your company has. More importantly, it gives you the information necessary to dig deeper into why your working capital is at its current levels.

While businesses generally want to avoid negative working capital, this doesn’t mean that high working capital is always desirable. If high working capital stems from excess inventory or not investing extra cash in growth opportunities, this could indicate operational inefficiencies that could hurt the business in the long run.

The most important aspect of a working capital analysis is that it tells you if your company is able to meet its current liabilities (or short-term financial obligations). Evaluating your total working capital and current ratio will tell you if your company can cover its expenses.

Regardless of the specific numbers for your ratios, using the working capital analysis to identify and address financial issues or operational inefficiencies will help your company enjoy a more stable and profitable future.

How to Calculate Your Net Working Capital

The first step of a working capital analysis is to calculate your net working capital. Add up the total value of your current assets, which includes cash, accounts receivable, and inventory that can easily be liquidated. Then, subtract the total of your current liabilities, which includes debts, rent and utilities payments, and accounts payable.

The formula for calculating your net working capital looks like this:

Short-term Assets – Short-term Liabilities = Net Working Capital

Related: Working Capital Calculator

How to Analyze Your Short-Term Working Capital

When deciding how to analyze working capital, one option is to focus entirely on your short-term working capital—or assets and expenses that have the most immediate impact on your financial situation. Focusing on the following areas will help you understand your business’s ability to manage its most time-sensitive expenses.

Determine When Current Liabilities Are Due for Payment

Start by reviewing your current liabilities—such as rent and utility bills or outstanding invoices from vendors. For your short-term working capital analysis, you could limit your analysis to liabilities that are due for payment within the next month or quarter. This tells you how many liquid assets your company needs to cover these upcoming expenses.

Use Your AR Aging Report to Determine Incoming Cash Flows

Your accounts receivable aging report is also a valuable part of a short-term working capital analysis because it tells you which customers have upcoming payment due dates (as well as track overdue payments). This lets you quickly identify the incoming cash flow for the same period as your current liabilities. These pending accounts receivable represent an inflow for your working capital so you can determine if you will have enough liquid assets available to manage your business’s expenses.

How to Perform a More Holistic Working Capital Analysis

While a short-term analysis can help you manage your business’s immediate financial needs, a holistic and comprehensive view of your working capital can be even more helpful for planning and managing your finances. The following actions should be part of this more in-depth approach.

Regularly Calculate Your Working Capital Ratios

A working capital ratio analysis can go a long way in explaining the overall financial health of your business, as well as how efficiently it is able to use its working capital.

Working Capital Ratio

Current Assets / Current Liabilities

Generally speaking, it is recommended that companies have a working capital ratio between 1.5 and 2.0. A lower working capital ratio could indicate a company will have trouble covering expenses while a higher ratio means a business likely isn’t investing enough assets.

Working Capital Turnover Ratio

Net Annual Sales / Average Working Capital

The working capital turnover ratio measures how well a business is using its working capital to generate revenue. The higher the ratio, the more efficient the company is at using its assets to generate sales.

Cash Conversion Cycle

Days Inventory Outstanding + Days Sales Outstanding – Days Payable Outstanding

This ratio measures the number of days it takes to convert working capital into cash. The lower the number, the faster your sales process and the more efficient your cash flow.

Regularly Calculate Your Liquidity Ratios

Consistently calculating your liquidity ratios can also give you a greater understanding of the financial health of your business.

Current Ratio

Current Assets / Current Liabilities

This is the same as your working capital ratio. It’s recommended to have a current ratio between 1.5 and 2.0 to ensure you can cover all current liabilities. This includes all current assets, including assets that may not be able to be immediately exchanged for cash. The current ratio is typically used to determine if you can pay off all short-term obligations within one year.

Quick Ratio

(Cash + Marketable Securities + Accounts Receivable) / Current Liabilities

In addition to cash, the quick ratio includes other assets that can be quickly exchanged for cash. It excludes current assets that could take longer to convert to cash.

Cash Ratio

Cash and Equivalents / Current Liabilities

The cash ratio is the strictest ratio for calculating liquidity because it only includes cash and cash equivalents. By focusing on your most liquid assets, this ratio helps you understand how much of your assets are immediately available to cover liabilities, even in case of insolvency.

Track Period-to-Period Changes to Your Ratios

While working capital and liquidity ratios are helpful, they become far more valuable when you compare them to prior reporting periods. A working capital trend analysis that looks at how your ratios compare to the previous reporting period or the same reporting period from last year helps you get a better idea of the overall direction of your company’s finances.

If your working capital has declined significantly since the last period, this is worth investigating further. Alternatively, if you identify seasonal fluctuations in working capital, you can adjust how you manage your finances so that you can consistently meet financial obligations.

Determine the Causes Behind Changes in Working Capital

Determining the causes behind changes in working capital can help you identify areas for improvement so you can make your business more financially stable. Accounts receivable, accounts payable, inventory management, business purchases, and loans are just a few activities that could cause changes in working capital.

By identifying which activities are responsible for changes in working capital, you can make better-informed decisions regarding how you’ll handle financial activities moving forward.

Stay on Top of Your Working Capital by Repeating These Steps Each Period

A working capital analysis can’t be viewed as a one-time activity. Your financial activities are constantly in motion. Repeating this analysis with each reporting period (monthly, quarterly, and yearly) will ensure you are always up to date regarding your overall financial position. You’ll be able to spot trends and take action to maintain financial stability.

How to Interpret Your Working Capital Analysis

Interpreting your liquidity and working capital analysis ultimately comes down to a few key factors: crunching the numbers, and then digging deeper to understand the “why” behind them.

First, consider your net working capital and your working capital ratio. Do you have a positive working capital? Is your working capital ratio within the recommended 1.5-2.0 range? How do your numbers compare to prior reporting periods? The answers to these questions will give you a quick understanding of whether your business is in a good financial position.

Because assets and liabilities can vary wildly based on your company’s size and industry, it’s best to emphasize the working capital ratio rather than your net working capital. A ratio of less than 1.5 means you may need to eliminate expenses or find ways to increase profit margins. A ratio higher than 2.0 means you should be looking for ways to invest in additional growth to make the most of your available resources.

Next, you must look into the reasons behind the numbers. If you have negative working capital, is it the result of seasonal fluctuations or an unusual business expense, or is it part of an ongoing trend of insufficient revenue? If your working capital ratio is too high, what investment opportunities could you be pursuing?

Critically evaluating the reasons behind your working capital numbers will help you identify opportunities to improve them, whether that be through obtaining loans or reducing expenses.

In Summary: How to Analyze Your Working Capital

Working capital management isn’t easy, but by understanding how to do a working capital analysis and then performing these analyses on a consistent basis, you’ll have the information you need to better manage your assets.

By regularly evaluating your current assets, current liabilities, and how they influence your overall financial picture (particularly in regard to your working capital ratios), you’ll be able to make better decisions to ensure the long-term stability of your business.

Working Capital Analysis FAQs

What are the relevant working capital analysis ratios?

The primary ratios for working capital are the working capital ratio, working capital turnover ratio, and the cash conversion cycle. The working capital ratio, also known as the current ratio, is determined by dividing current assets by current liabilities. The working capital turnover ratio measures a company’s efficiency in generating revenue from working capital. Finally, the cash conversion cycle measures how many days it takes to convert working capital into cash flow.

How should a business use a working capital analysis?

A business should use its working capital analysis to evaluate its short-term financial health. Current assets should exceed current liabilities to ensure a company can cover its financial obligations. Consistently performing a working capital analysis helps businesses identify trends and correct any financial behaviors that could hurt their long-term stability.

What causes changes in working capital?

Accounts receivable and accounts payable, inventory management, business purchases, and loans are common areas that can change a business’s total of current assets or current liabilities. Activity in any of these categories can cause a change in working capital from one reporting period to another.

What are the three liquidity ratios?

The three liquidity ratios are the current ratio, the quick ratio, and the cash ratio. The current ratio measures a business’s current assets divided by its current liabilities. The quick ratio totals a business’s cash, marketable securities, and accounts receivable and divides that by its current liabilities. Finally, the cash ratio simply divides a business’s total cash and equivalents by its current liabilities.