Working capital or net working capital is the cash your business needs to pay its bills and keep operating successfully. It might not sound as glamorous as profit but it’s the money your business requires to meet day-to-day expenses and seize opportunities for growth.
“As the daily lifeblood of any business, working capital is essential to maintain the smooth running of a business,” says John Edwards, Chief Executive Officer of The Institute of Financial Accountants.
Here’s a look at what working capital is, why it's important for business resiliency and growth, and how you can calculate the working capital needs of your own business.
What does working capital mean?
Net working capital (NWC) is the money a business needs to run its day-to-day operations, such as paying salaries and suppliers, as well as rent and other overheads. It’s known as ‘working’ because it refers to the funds a business can easily release to pay for bills and expenses.
In other words, working capital can be accessed quickly because it’s not locked away in long-term business assets or investments.
What is negative net working capital?
Negative working capital is when a company’s current liabilities (e.g. bank overdrafts and salaries) exceed its current assets (e.g. cash-at-bank). This means that there is more debt than assets available to pay it off.
What is positive net working capital?
Positive working capital is when the value of a company’s current assets is greater than its current liabilities. This means the company has sufficient cash to cover its obligations.
How is working capital calculated?
Working capital is calculated by subtracting your current liabilities (what you owe) from your current assets (what you have). A positive number means you have enough cash to cover short-term expenses and debts, whereas a negative number means you’re struggling to make ends meet.
Examples of working capital: If you have £50,000 cash in the bank and you owe £5,000 to suppliers and £10,000 in salaries, your net working capital is £35,000.
What’s the difference between net working capital and cash flow?
Working capital might sound the same as cash flow (both figures reflect your business’s financial state) but there are some important differences.
Your cash flow statement shows how much cash your company makes in a given period (typically over one month). It tells you how much is coming in and going out, and it also tells you your balance.
However, your cash flow statement doesn’t reveal how effectively you’re managing your finances or how much leeway you’ll have if sales hit a rough patch or if you run into problems with your supply chain. This is because cash flow shows how much money moves in and out of the business in a specific period, but doesn’t subtract your liabilities.
On the other hand, working capital considers money coming in (accounts receivable) and money you owe (accounts payable) alongside other liabilities, thereby providing a clearer idea on how well-equipped you are to ride out unforeseen storms, as well as pay your debts, outgoings, and payments.
Why is working capital important?
Understanding your working capital requirements will help ensure your business is able to sustain itself and be prepared for the future. This means having enough money available at your fingertips to pay your suppliers, employees, rent, maintenance costs and other overheads, while also having surplus cash for emergencies or to reinvest in new opportunities.
Knowing your level of working capital and taking measures to improve it helps you:
- Finance your day-to-day operations
- Meet upcoming expenses
- Keep relationships with suppliers healthy
- Show lenders your business is in a good financial state
- Assess the success of your business over time
- Weather slow sales periods and times when cash flow is tight
- Invest cash back into the business to fuel growth
What is the working capital cycle?
Another figure that can be extremely helpful when managing your cash flow and forecasting how much cash you’ll need until you receive your next payment(s) is the working capital cycle.
The working capital cycle is the amount of time that passes between using your cash to purchase stock and ultimately receiving money for the sale. The number of days that comprise the working capital cycle is how long the business is out of pocket before receiving payment in full for its inventory. If the number is above zero, it’s a positive cycle. If it’s less than zero, it’s negative – a negative (shorter) cycle is better.
The goal is to shorten the cycle as much as possible so that you’re out of pocket for the shortest possible time.
What is working capital finance?
Working capital finance is when a business borrows money to plug a working capital gap. This could be in the form of a term loan, a business line of credit or invoice financing. “It’s often used for specific projects designed to grow your business, such as taking on a bigger contract or investing in a new opportunity,” says Edwards. But it can also be useful in equipping your business with the funds it needs to meet day-to-day expenses.
For seasonal businesses such as the tourism sector, working capital finance can be particularly beneficial in managing peaks and troughs through summer and winter months, Edwards says.
How to improve working capital
No matter which industry you’re in, the three things that affect your net working capital are:
- Your receivables (or debtors)
- Your stock
- Your liabilities (payables or creditors)
The relationship between these three factors decides your working capital. To improve your working capital, you must adjust one or more of these factors so that you can retain cash in the bank for longer.
Your receivables (or debtors)
Use strategies to give you every chance of receiving payment on time from clients and customers. This could include discounting orders that are settled earlier, using automated emails to send reminders and chase overdue payments, and giving shorter payment terms whenever your clients will allow it.
Holding too much stock ties up cash, whereas having too little risks missing out on valuable sales. Use forecast analytics and smart inventory management to strike the right balance. “Using software can help you better identify any issues such as items which are not selling,” says Edwards. “For retail businesses for instance, it is crucial to have point-of-sales integration with your system to provide real-time updates on all items.”
Your liabilities (payables or creditors)
The more time you have to pay your suppliers, the longer you get to hang onto cash in the bank. Try to negotiate the longest payment terms possible. Edwards also suggests seeing whether you can reduce any debt servicing expenses, such as interest or loans, by negotiating a better rate of comparing rates with other lenders.
When cash flow is tight, you can use an American Express® Business Card to pay suppliers on time while getting up to 54 days to pay us back. You thereby have more working capital to use for longer¹.
1. The maximum payment period on purchases is 54 calendar days and is obtained only if you spend on the first day of the new statement period and repay the balance in full on the due date.