Working capital and operating liquidity are the lifeblood of any business. These calculations are simple and quick ways for business managers, investors and lenders to make financing and investing decisions. Without sufficient liquidity -- enough working capital to operate in the current year -- a business cannot react to market changes, take advantage of new business opportunities or even pay the employees who keep the business running. The working capital calculation and the liquidity ratio are two useful tools to determine the viability of a business.
Add up all current assets. Current assets are those that are cash or cash equivalents, assets that can be quickly converted to cash and assets that will be used up during one business cycle, usually within one fiscal year. In addition to cash, current assets include short-term investments and marketable securities, fixed assets, inventory, accounts receivable, current year prepaid expenses and any other assets that could be converted to cash during the current year.
Add up all current liabilities. These are all debts owed and payable by the end of the fiscal year or business cycle. They include short-term loan debt, accounts payable, accrued liabilities, dividends payable, unpaid taxes and any other debts payable within one year.
Subtract total current liabilities from total current assets. The result is the company's working capital. For example ZYX Company has $500,000 in current assets and $250,000 in current liabilities. Its working capital is $250,000 ($500,000 - $250.000). If the company paid all its current debts, it would still have $250,000 of working capital to operate the business.
Calculate a company's liquidity ratio to determine the financial health of the business. The standard ratio for a healthy company is two. ZYX Company, with $500,000 in current assets and $250,000 in current liabilities, has a ratio of two ($500,000/$250,000), and is a healthy company. The liquidity ratio should be a part of regular business planning and should be computed each month. Any time the ratio falls below 2, managers need to act quickly to identify problems and make adjustments.
The liquidity ratio is also useful to determine the health of a current or potential customer before increasing or extending credit.
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