Two business formulas that happen to be essential for business owners but aren’t often discussed are the Working Capital formula and Current Ratio formula. These provide a quick understanding of a business's ability to convert its assets into cash and then resolve its debts. Hence why we have decided to explain what they entail in as simple of a manner as possible.
Working Capital is the amount of capital that will be leftover if all of the business's current assets (which are assets that are easily converted into cash over the course of the year, such as Accounts Receivables) are used to pay off all of its current liabilities (which are debts that are due within the next year, such as Accounts Payable). So the simple formula is effectively: Working Capital = Current Assets – Current Liabilities.
If you have an excess in working capital, you essentially have extra resources to put towards other aspects of your business, such as investing or something else that will improve your business’ fortunes. But if your working capital is within the negative then your business lacks the current ability to pay off its debts should the need to liquidate its assets come about, meaning that you will need to take measures to remedy that.
Likewise, the Current Ratio is another measure that is used to provide a simplified number that can be best used when comparing your business against others. The higher the ratio resulting from the formula, the better its ability to resolve its debts if something comes up. The formula involves taking the Current Assets and dividing them against the Current Liabilities: Current Ratio = Current Assets / Current Liabilities.
Banks and other investors often use these formulas to determine whether a business is stable enough to provide a loan or invest in. There’s little to be gained in providing cash to a business that can’t pay its debts off, so knowing these two formulas are essential for business owners.
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