How to calculate working capital

business.gov.au defines working capital as the cash a business has available for its day-to-day expenses, and says a balance sheet helps you work it out. In practice it is calculated from balance sheet figures: working capital equals current assets minus current liabilities.

Both sides use the same time limit. business.gov.au counts cash as a current asset, along with anything you expect to turn into cash within 12 months. A liability is current when it has to be paid within the same 12 months. Longer-term items, such as equipment or the later years of a loan, stay out of the calculation.

Working capital is measured at one date, usually the last day of a month or of the financial year. The answer is only as complete as the books on that date, so before you start:

• reconcile the bank and credit card accounts to their statements at that date
• enter every customer invoice issued and every payment received up to that date
• enter every supplier bill for goods or services received up to that date
• update the stock figure from your inventory records or a recent stocktake
• count petty cash.

If your books use cash accounting, they won't hold what customers owe you or what you owe suppliers. business.gov.au makes the same point about cash accounting. Add those amounts from your lists of unpaid invoices and unpaid bills before you calculate.

Go through the asset accounts and pick out the short-term ones. business.gov.au's balance sheet template lists these under current assets:

• cash
• petty cash
• inventory
• prepaid expenses.

Money customers owe you belongs here too. business.gov.au describes accounts receivable as the short-term amounts, under 12 months, that customers still need to pay.

Leave out vehicles, equipment, property and other fixed assets, even if you could sell them quickly. If some customer debts are unlikely to be paid, which business.gov.au calls bad debts, note them separately and ask your accountant how they should be treated.

Next, take the liabilities due for payment within 12 months. business.gov.au's balance sheet template places credit cards payable, accounts payable, interest payable and accrued wages under current liabilities.

A loan repaid in instalments needs care. The template treats loans due after a year or more as long-term liabilities, but the part of the loan balance to be repaid in the next 12 months is generally counted as current. Your lender's repayment schedule shows the split between the loan and interest, and your accountant can confirm the amounts.

Look also for amounts owed that haven't been billed yet, such as wages staff have earned since the last pay day. Leaving them out makes current liabilities look smaller than they are.

Here current assets are larger than current liabilities, so working capital is positive. A negative result would mean the debts due within 12 months are greater than the short-term assets available to meet them.

Before you use the figure, check that both totals agree with the balance sheet for the same date, and that no account has been left out or counted on both sides.

Not every current asset can pay a bill next week. business.gov.au defines liquidity as the speed at which assets can be turned into cash, and its cash flow guidance points out that money tied up in unsold stock isn't available to spend.

A stricter check leaves out inventory and prepaid expenses, and compares only cash, petty cash and accounts receivable with current liabilities. In the example, those come to less than current liabilities, so the wholesaler is relying on selling some of its stock to meet everything due within 12 months.

Dividing instead of subtracting gives the same comparison as a ratio, often called the current ratio, which is easier to compare across dates as the business grows. Neither figure says when each bill falls due. A cash flow forecast does that.

One calculation is a snapshot. Work it out the same way at the end of each month and keep the results side by side, so you can see whether working capital is building up or shrinking, and which line is driving the change. Watch for:

• accounts receivable rising faster than sales, which can mean customers are paying more slowly
• inventory building up without a matching rise in sales
• accounts payable and the credit card balance climbing, which can mean bills are being held back
• cash falling while profit holds steady.

business.gov.au lists customers often paying late, and finding it hard to pay suppliers or debts, among the signs of a cash flow problem. It also suggests checking the business's financial health at least once a year, with the balance sheet among the documents you review.

business.gov.au's suggestions for improving cash flow line up with the parts of the calculation. Most of them turn stock or receivables into cash rather than raising the total:

• Collect money owed sooner: send invoices earlier, update your payment terms and chase payments that are overdue.
• Hold less stock: keep stock levels from getting too high, and clear out stock that isn't selling.
• Agree on supplier terms that suit you, such as 60 days to pay instead of 30.
• Turn assets the business has stopped using into cash by selling them.

Collecting sooner and holding less stock turn other current assets into cash, and longer supplier terms keep cash while the bill stays owing, so none of them changes the working capital total on its own. They make more of it ready to pay bills. Check the timing in a cash flow forecast before counting on them, and for help with your own position, business.gov.au suggests talking to an adviser such as your accountant.