Working capital is what makes the business world go round. It’s at the heart of every thriving enterprise, from fintech start-up to craft brewer. A barometer of financial health. A key management tool.
But what exactly is working capital? How do you put a figure on it? Why is it so important? And how do you use it to grow your business?
In this essential guide, we cover the basics, clear away the jargon and look at what it takes to get a firm grip on effective working capital management.
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To use a textbook definition – working capital is a cash balance, positive or negative, showing the difference between current assets and current liabilities.
In other words, it's the cash your business has left, after you account for money coming in and money going out over the next 12 months.
We’ll get into what those current assets and liabilities are later in How to calculate working capital.
But the main takeaway for now is that keeping an eye on working capital tells you a lot about how efficiently you’re running your business.
You’ll sometimes see the term net working capital instead of working capital.
That’s because the amount is net of liabilities – it’s cash coming in or on the books minus debts and payments coming due.
Gross working capital is the total of all current assets before you subtract current liabilities. But as the gross figure isn’t all that useful, it’s rarely used.
Hence, when talking about net working capital, ‘net’ is usually dropped.
TLDR: working capital = net working capital.
What’s the difference between working capital and cash flow? Well, at first glance it might seem like they’re the same. But mix them up at your peril. Because, 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. You can see how much money comes in and how much goes out – and the balance.
But what it doesn’t tell you is how well you’re managing the flow. Or how much wiggle room you have if sales hit a dry patch or a supplier hikes the price of raw materials.
In contrast, working capital gives you a much bigger picture of how efficiently you’re managing the flow of cash through the business. Whereas cash flow doesn’t include money you’re due to receive (accounts receivable) or money you owe (accounts payable), working capital accounts for these too.
So, working capital gives you a snapshot of how well your business is geared up to ride the ebbs and flows of money moving through your business. It shows what scope you have for accessing money you haven’t yet received to meet debts, outgoings and forthcoming payments.
This gives you flexibility to ride out short-term setbacks and capitalise on new opportunities.
It can also flag up cash flow bottlenecks and idle cash surpluses. Which can help you see where you could improve your overall use of capital.
Working capital is important because it provides customers, suppliers, creditors and potential investors with information about how your business is running. It's a bit like looking into a magic mirror, and can provide evidence of whether your business is a well–oiled machine or if there are signs of trouble ahead.
How soundly are you managing day-to-day operations? Can you comfortably meet all your short-term obligations? What scope do you have for unforeseen events?
The clues are all in your balance sheet.
Cut your working capital too fine and you could end up missing out on opportunities for short-term gain. If a competitor’s supply chain breaks down or an R&D breakthrough comes early, you want cash in the tank to respond.
Likewise, if cash flow gets squeezed because stock isn’t moving, you still need cash in reserve to meet payroll costs and settle bills on time.
The goal is to keep enough liquidity to roll with the punches short-term, and prosper and thrive long-term.
And if you can achieve this without taking on new debt, so much the better.
If not, well, there’s always working capital finance. But we’ll come to that later.
Working capital also plays a starring role in business growth and expansion.
Rather than siphon off surplus from your cash flow, you might choose to boost funds through working capital financing.
This can help you consolidate your market position, capitalise on new developments and accelerate your growth path.
More about this in How a working capital loan can help your business grow.
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You calculate your business’s working capital by taking the total of all your current assets and subtracting the total of all your current liabilities.
So the working capital formula is: WORKING CAPITAL = CURRENT ASSETS - CURRENT LIABILITIES
For accounting purposes, current assets are any assets that can be turned into cash within the next 12 months; current liabilities are any debts or other payable items coming due for payment within the next 12 months. If your business has an accounting period of less than 12 months, you can use that instead.
Your working capital figure will be a cash amount and can be positive or negative.
As a rule, positive working capital is a good sign, negative working capital not so good. But neither of these statements is true all the time. We'll explore this in more detail in Positive working capital and Negative working capital.
Current assets typically include cash held in current and savings accounts, inventory, accounts receivable, pre-paid expenses and short-term investments. On the other hand, current liabilities include the usual costs of running a business, such as rent, utilities, materials and supplies; accounts payable; deferred revenue; accrued expenses; and accrued income taxes.
Before you calculate your working capital, you'll need to balance your assets and liabilities. That's all the things your business has coming in, minus any business expenditures.
So, to recap:
Current assets include:
Current liabilities include: t
Let's talk liquidity. And what effect it has on the financial stability of your business.
How can you tell, just by looking at your working capital, how well you're set up to weather a financial storm?
Trick question. You can’t. At least not from the net working capital figure alone. Not without weighing up your total current assets against your total current liabilities.
To do that, you need to work out your working capital ratio.
Take your current assets total and divide this amount by your current liabilities total.
WORKING CAPITAL RATIO = CURRENT ASSETS / CURRENT LIABILITIES
This will typically give you a figure in a range from 0.5 to 3.0.
If cash coming in outweighs cash going out, this will be more than 1.
If cash going out outweighs cash coming in, it will be less than 1.
We'll look at what your working capital ratio reveals in a moment.
First, let's run some numbers.
Consider the difference between Company A and Company B.
Crunch the numbers 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 working capital ratio of 3.0. Company B has working capital ratio of 1.2.
See how the working capital ratio is starting to tell us more about the way the business is run?
Company A seems to be awash with 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.
But let’s not jump to any conclusions. For any of this to mean anything, we must first put these figures in context.
If you're familiar with the term current ratio, you might be wondering what’s the difference between the current ratio and the working capital ratio.
After all, the current ratio is a simple formula you can use to calculate liquidity. It gives you an overview of a business's ability to meet short-term obligations – debts you need to pay back within a year.
See any difference? No. The current ratio is the same thing as the working capital ratio.
When cash is king, inventory cuts no ice. The quick ratio takes this into account.
The quick ratio pares your current asset list back to include only the most liquid.
So out goes inventory and out goes accounts receivable. 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?
For that reason, the quick ratio is also known as the acid-test ratio.
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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 working capital 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.
Lack of cash can kill business. Money management is one of the biggest challenges for SMEs, especially start-ups. The Office for National Statistics reports that only 43.2% of new business ventures started in 2012 survived more than five years.
The good news is you can take immediate steps to start improving your working capital efficiency. We’ll get into some of the strategies for effective working capital management in a moment. Before we do, let’s dive into positive and negative working capital in more detail.
What is positive working capital? Quite simply, you have more coming in than going out. Your working capital ratio is higher than 1.0.
You can more than meet your debts from the cash you’re generating and the assets you can readily turn into cash within the next 12 months.
Your business looks in good shape. Lenders are likely happy to talk.
But take note. You can end up being too positive. A good range is 1.1 to 2.0. Any higher and you might want to dig into why your liquid assets are more than double your liabilities.
If cash levels are low and your working capital ratio is, say, 2.9, heed the warning bells.
It could mean you’re letting inventory stack up, collecting money owed to you too slowly or paying your vendors too soon. Carry on like that and you could head for a cash shortage.
If you’re cash-rich, with a similar highly positive working capital ratio, then it could be worth investing your money. Are you more focused on liquidity than growing your business?
All said, some business sectors are more prone to high levels of working capital than others. Especially at certain times of the year, if demand is seasonal.
What is negative working capital? In short, a heads-up you have more going out than coming in. Your working capital ratio is lower than 1.0.
Your cash flow management has room for improvement. Time to play detective.
Three things to look into:
Are you getting orders out the door fast enough? Selling the right product or service to the right people at the right price? Too lax in chasing your customers for payment?
As with positive working capital, the key is to look for patterns. Maybe your capital balance constantly fluctuates from negative to positive.
Acceptable negative capital levels vary from industry to industry. A fast food outlet needs little cash in hand. It might even take cash in faster than it pays its suppliers for what goes out the door.
It’s business, after all. You can only read the runes once you know what to watch for.
What's normal for one business might be a brown trousers moment for another.
Simplest step of all is to stretch things on both sides. See if you can negotiate better credit terms with your suppliers. And chase your customers to settle sooner.
Get stock control down to a fine art. Keep inventory to a minimum. Hold off on buying raw materials. Become a master of just-in-time procurement. In other words, get slicker.
One of the key metrics to focus on is your working capital cycle. How many days does it take bring in the cash from stock or invoices? How long do you sit on debt until you pay?
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 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.
Working capital is the oxygen your business needs to stay afloat and prosper. Managing the movement and use of capital is the first essential. But sometimes is can be useful to have access to an extra flow of money.
For many small businesses, some form of working capital funding 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:
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.
You can’t grow your business if you’re not investing in it. With a working capital loan, opportunity need never pass you by.
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 market, invest in system upgrades, step up R&D. The list goes on.
When crisis comes calling or opportunity knocks, it's good to be able to act – and fast. When you want or need credit, it can be frustrating to wait. This is sometimes something you can be forced to do with high street banks.
Cue the business finance specialist. You could apply in minutes, get the nod in hours and the funds in your account next day.
The content of this article does not constitute financial advice and is provided for general information purposes only.
Martin Brackstone is a senior editor and copywriter who has years of experience writing about a broad range of topics, including business finance, pensions, home and motor insurance, premium bank accounts, reward credit cards and personal loans.
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