What is working capital and how is it calculated?
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Working capital is what keeps your business moving – it’s the available liquidity in your company to maintain a positive cash flow, funding operations and meeting your obligations. By managing your working capital effectively, you can ensure you have enough cash to hand to respond to changes in your market, invest where it matters and cover your costs without going into debt.
Here we’re going to cover the basics you need to know about working capital, how it works and how to cover working capital gaps when you need it most.
What is working capital?
In the simplest terms, working capital is what you have, in assets and cash, minus what you owe and it’s one of the most important figures to keep track of in your business. By looking at the amount of money you have coming in over a certain period and subtracting your costs, the changes in working capital tell you a lot about how efficiently you’re running your business.
If you find yourself operating with negative working capital on a regular basis, it’s a sign you’re either spending too much or making too little.
Note: you’ll sometimes see the term net working capital instead, since the amount is ‘net’ of liabilities – instead of gross working capital, which is the total of all current assets before you subtract current liabilities.
Why is working capital important?
Working capital is essential because it’s a measure of your financial health for that period. By looking at your assets minus your liabilities shows that you have enough cash to meet your costs, meaning you can keep trading.
This isn’t a trivial issue – this year 31% of UK business owners fear closure by the end of 2024 and running out of cash is the most common reason. By keeping track of your working capital on a regular basis you can not only ensure you have the flexibility you need to adapt to changes in your market, but also use it to analyse how efficiently you’re running the business, including:
- How long does it take to turn inventory into revenue?
- Are my customers paying on time?
- Am I turning my investments into growth in an appropriate time frame?
What’s the difference between working capital and cash flow?
Despite some overlap, working capital and cash flow each give completely different information about your business’s financial state.
- Your cash flow statement tells you how much cash your business generates in a given period as a single figure. You can see how much money comes in and how much goes out – and the balance.
- Working capital tells you how well you’re managing the flow of cash in and out. Or how much wiggle room you have if sales hit a dry patch or a supplier hikes the price of raw materials.
How to calculate working capital
The basic formula for working capital is: Working capital = current assets - current liabilities.
The larger the figure, the more liquidity you have available. It’s also important to note that this figure can be positive or negative.
What is the working capital ratio?
While the working capital formula gives you a basic look at the capital you have available, it doesn’t give you the context for it. For that, you need the working capital ratio.
The working capital ratio shows you your assets relative to your liabilities, and it calculated as:
Working capital ratio = current assets / (divided by) current liabilities
Working capital ratio example
Consider the difference between Company A and Company B.
- Company A has current assets of £1.5 million and debts of £0.5 million.
- Company B has current assets of £6 million and debts of £5 million.
Working through the working capital formula (subtraction) and we see both businesses have the same amount of working capital: £1 million.
But put those same totals through the working capital ratio formula (division), and we see a big difference.
Company A has a ratio of 3.0. Company B has a ratio of 1.2.
This extra level of detail with the working capital ratio is tells us more about the way the business is run.
- Company A has plenty of cash to pay the coming year’s debts. Then again, could it make better use of all that spare cash – to fund expansion, perhaps, or generate a higher return?
- Company B’s financial position is more finely balanced – a sudden drop in sales or bump in overheads in the next 12 months could trigger a cash flow crisis.
What is the quick ratio?
The quick ratio is a working capital formula based just on liquid assets.The goal here is to show what you have available right now So out goes inventory and out goes accounts receivable.
After all, stock takes time to shift and money owed to the business isn't cash until the bill is paid. A less stringent analysis might choose to include accounts receivable. With terms typically 30 to 90 days, this is seen as a near-cash asset.
Not so for inventory, which can likely only be rapidly liquidated at a heavy discount.
The quick ratio doesn't tell you everything, but it's a handy step on from the working capital ratio. The focus is on the short-term and answers a simple question: With our backs against the wall, do we have enough cash to pay our bills?
How to understand changes in working capital
No business stands still. Yet your working capital balance and your working capital ratio are mere moments in time.
The figures project 12 months into the future. And, like your balance sheet, they shine a light on your financial well-being for the current accounting period and no more.
Useful as that is, it’s only when we compare this year’s numbers with previous years that we begin to see the wider picture.
A ratio of 1.1 takes on entirely different meaning if previous years were all between 0.7 and 0.9 versus a five-year run from 2.9 to 2.0.
The first example suggests a business has finally turned things around and addressed its cash flow problems. The second could mean sales are in long-term decline or debts and running costs are rising faster than revenue. So, as with all financial analysis and operational evaluation, the trend tells us more than this year’s numbers alone.
And, when we're actively looking to improve working capital, keeping a watchful eye on changes quarter to quarter can give us a valuable window on progress.
How to manage your working capital
Lack of cash can kill business. Working capital management is one of the biggest challenges for SMEs, especially start-ups. According to the most recent figures, of businesses founded in 2016, just 38.5 percent were still operating in 2021, and the most common reason is running out of cash.
The good news is you can take immediate steps to start improving your working capital efficiency.
Shorten your working capital cycle
The working capital cycle measures the time it takes a business to convert its net working capital all to cash. Again, this varies from business to business and sector to sector.
So you might start by comparing your own working capital cycle with your industry norms. From there, you have a marker by which to gauge your journey towards better working capital management.
Operational efficiency isn't all working capital is good for. Once you've got your house in order, you might want to prime your business for increased stability and readiness to deal with whatever good times and bad times the future holds.
To fast track that, it’s worth exploring your options for specialist working capital credit.
Take out a working capital loan
For many small businesses, some form of working capital loan gives them valuable breathing space. Knowing you have a line of credit you can call on adds a reservoir of flexibility, efficiency and security to day-to-day operations.
Here are just a few ways businesses use working capital loans:
- pay upfront for stock
- get volume discounts
- bridge a cash flow gap
- launch a marketing campaign
- meet variable payroll demands
- pay suppliers on time
Where working capital financing can really pay off is that you’re leveraging assets you wouldn’t otherwise have available to optimise cash flow and increase profitability. Get this well tuned and you create a virtuous cycle.
How a working capital loan can help your business grow
With positive working capital it's possible to go after bigger contracts, invest in stock and maybe even staff. You might also be able to negotiate discounts with key vendors because you can guarantee paying them up front. Then there's the option to fund expansion into new markets, invest in system upgrades, invest in R&D or hire more staff.
We designed our iwoca Flexi-Loan around the working capital needs of small businesses – borrow from £1,000 to £1,000,000, with decisions in 24 hours to keep your business moving forward.
The content of this article does not constitute financial advice and is provided for general information purposes only.
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