While there are many different ways to calculate working capital, there are simple calculations you can leverage to demonstrate the current financial state of your firm. Let’s take a look at three common formulas you can use.
The basic net working capital formula looks like this:
Working Capital = Current Assets – Current Liabilities
Another way to measure working capital is by expressing it via the Current Ratio.
|Current Ratio =
Then there is the Acid Test Ratio, which is similar to the Current Ratio, but excludes certain types of current assets.
|Acid Test Ratio =
|(Cash + Cash Equivalents + Short Term Investments
+ Current Receivables)
To compare, while the Current Ratio includes all Current Assets, the Acid Test only includes cash, cash equivalents, short-term marketable securities, and accounts receivable. Meaning it excludes inventory, prepaid expenses, and deferred income tax.
Now that you know how to calculate these simple formulas, let me explain how to analyze the results for each.
If you have a negative working capital value (meaning current liabilities exceed current assets), or the Current Ratio has a result below 1.0, this is usually an indication that your firm may not be able to meet its short-term obligations. So, the higher the ratio, the better positioned your company is to meet those obligations.
However, if the result is too high, this also means your firm is not efficiently managing its short-term finances (more on this in the next section). While the ideal value of these ratios can vary by industry, typically the result for the Current Ratio should be above 1.2 and the Acid Test Ratio result should be above 1.0.