Put simply, working capital is the cash your business requires to pay its bills and keep operating successfully. That means having enough money available at your fingertips to pay your suppliers, employees, rent, maintenance costs and all other overheads. It is really important to have a detailed understanding of your working capital to ensure your business is able to sustain itself and be prepared for the future.
You calculate working capital 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.
What’s the difference between working capital and cashflow?
Working capital might sound the same as cashflow (both figures reflect your business’s financial state), but there are some important differences. Your cashflow 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 cashflow 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 cashflow 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 understanding working capital so important?
It’s one thing to have an idea of your predicted turnover in a given month, quarter, or year, but you'll also need a more detailed picture of your business’s finances if you want to survive long-term, let alone grow.
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 cashflow is tight
- Invest cash back into the business to fuel growth
No matter which industry you’re in, the three things that affect your 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.
How do you calculate working capital?
Working capital = current assets - current liabilities
Anything owned by your business that can be converted into cash within 12 months is a current asset. They may include:
- Cash equivalents (investments that can be quickly converted into cash, like government bonds)
- Accounts receivable
- Stock (including raw materials, work-in-process, finished goods and packaging)
- Short-term investments
- Pre-paid expenses
Current liabilities include any bills that you haven’t paid yet, including:
- Accounts payable (e.g. supplier payments)
- Bank overdrafts
- Sales, payroll, and income taxes
- Short-term loans
- Outstanding expenses
Let's use an example: if the balance sheet for Quality Bathrooms Limited shows total assets of £300,000 and total current liabilities of £200,000, then the company’s working capital is £100,000 (assets - liabilities).
The working capital ratio
Sometimes it’s more useful to see the ratio of assets to liabilities than the raw numbers.
The formula for working capital ratio is:
Working capital ratio = current assets / current liabilities
Using figures from the balance sheet above, the working capital ratio for Quality Bathrooms Limited would be:
300,000 / 200,000 = a working capital ratio of 1.5
It’s useful to know what the ratio is because, on paper, two companies with very different assets and liabilities could look identical if you relied on their working capital figures alone. For example:
- Company A has current assets of £1 million and liabilities of £500,000
- Company B has current assets of £5 million and liabilities of £4.5 million
Both companies have a working capital (assets - liabilities) of £500,000, but Company A has a working capital ratio of 2, whereas Company B has a ratio of 1.1.
A higher ratio means there’s more cash-on-hand, which is generally a good thing. A lower ratio means cash is tighter, so a slowdown in sales could cause a cash flow issue.
Generally speaking, a ratio of less than 1 can indicate future liquidity problems, while a ratio between 1.2 and 2 is considered ideal. If the ratio is too high (i.e. over 2), it could signal that the company is hoarding too much cash, instead of investing it back into the business to fuel growth.
The working capital cycle
Another figure that can be extremely helpful when managing your cashflow 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.
How to improve your working capital
Working capital is affected by the following three factors. By managing each factor as efficiently as possible, you can improve your working capital.
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.
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.
When cashflow is tight, a business charge card with a long payment period can help extend the amount of time you have to pay suppliers.
If you use an American Express® Business Card to pay suppliers, you get an additional 54 days to clear the card balance using cash. You thereby have more working capital to use for longer.1
Find out more about American Express Business Cards.
- 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.