Working capital is a key financial metric for gauging your short-term financial health. More specifically, it’s the funding your business needs to cover operating costs and short-term obligations on a daily basis.
To illustrate its importance, let’s consider an example:
Imagine you’re a toymaker who just closed the biggest order your company has ever received. You’re both ecstatic and concerned: here is the big opportunity you’ve craved, but how will you make it happen? There’s not enough inventory to meet the order. You can buy more today, but you don’t have enough cash in the bank to pay for it all. Some of your customers haven’t even paid their invoices yet, and you cross your fingers and hope they’ll pay you soon. You quickly realize that working capital is the one thing that will determine whether or not this order becomes your big break.
As a toy manufacturer, you need cash on hand for day-to-day operating expenses: that’s working capital. You need inventory: that’s also working capital. And the invoices that your customers pay 30 to 90 days later: the money trapped in them is working capital, too.
How to calculate working capital
Working capital formula:
Net working capital = current assets − current liabilities
Current assets are things you expect to turn into cash within a year, such as cash and cash equivalents (your most liquid assets), accounts receivable, and inventory. Current liabilities are short-term debts due within a year, like accounts payable, short-term loans, and accrued expenses such as payroll and taxes. You’ll find both numbers on your balance sheet.
Example: $150,000 in current assets minus $100,000 in current liabilities gives $50,000 in working capital.
Why does working capital matter?
Working capital is a measure of your liquidity, or how easily you can pay your short-term financial obligations. The less working capital you have, the greater the risk you run of having a cash flow crunch in which you struggle to buy new inventory or pay a bill. And without it, your company grinds to a halt completely.
But too much working capital can hurt a company’s finances, too. If an electronics manufacturer builds up too much inventory and it sits on a shelf long enough to become obsolete, then the company must write off the value of the inventory it can’t sell.
Working capital management involves finding the right balance between “too much” and “too little,” and keeping your operational efficiency high while you do.
What’s the difference between positive and negative working capital?
Working capital can land on either side of zero. Where yours falls will tell you a lot about how much breathing room your business has.
Positive working capital means your current assets are greater than your current liabilities. If you have positive working capital, you can cover your short-term financial obligations and still have money left over to invest, handle surprises, or grow. Lenders often like to see it, too. In ratio terms, that’s anything above 1.0, and many small businesses aim for roughly 1.2 to 2.0.
Negative working capital means you owe more in the next year than you have coming in. That can make it hard to make payroll, pay vendors on time, or handle an unexpected expense. But it isn’t always bad news. Restaurants, subscription businesses, and others that collect cash up front and pay suppliers later often run negative on purpose, because cash comes in faster than bills come due.
The overall number matters less than the reasoning behind it. Positive working capital that’s tied up in unsold inventory or slow-paying customers can feel just as tight as negative working capital, so check your number regularly, and know why it’s moving.
How to calculate working capital ratio
Working capital ratio formula:
Working capital ratio (current ratio) = current assets ÷ current liabilities
This liquidity ratio shows how comfortably your current assets cover your short-term obligations. Using the numbers from our previous example, ($150,000 in current assets and $100,000 in current liabilities) you would have a working capital ratio of 1.5.
What is the relationship between working capital and cash flow?
Earlier we defined working capital as the funding needed to operate on a daily basis, including cash. Working capital can also be thought of as “cash and things that will soon turn into cash,” also known as liquid assets.
This is important because at the end of the day, cash is what your business needs to meet payroll, buy more inventory, or pay expenses. Our toy manufacturer’s employees probably don’t want to be paid in toys—even if their kids would be very happy with that arrangement.
This means that within the category of working capital, different kinds of working capital are more or less immediately useful:
Cash can be used to meet expenses today.
Accounts receivable can’t be used to immediately meet expenses, but by using accounts receivable financing they can be converted quickly and easily to cash to meet those expenses.
Inventory can’t be used to meet immediate expenses, but if necessary you could have a sale to raise the cash you need to meet those expenses.
Good working capital management also tracks your cash conversion cycle: how many days it takes to turn inventory and receivables into cash, minus how long you take to pay your own bills. The shorter the cycle, the less cash gets tied up.
How to improve working capital for a small business
There are a number of ways to improve your working capital situation as a small business:
Speed up invoicing and collections. The faster you get paid, the sooner that money can go to work. Send invoices as soon as the work is done, make them easy to pay online, and follow up quickly on anything overdue. You can also offer a small early payment discount or charge a late fee on invoices that go unpaid past the due date.
Negotiate better payment terms. Ask your suppliers for longer payment windows, such as net 45 or net 60 instead of net 30. That gives you more time to collect from your own customers before your bills come due. Long-standing vendors are often open to it, especially if you pay reliably.
Watch your inventory. Back-of-the-envelope forecasting by smaller businesses can result in excess inventory. If you can improve your inventory management by trying to reduce your overall inventory, you’ll add more cash to your bank account.
Pro tip: If you have multiple products, look at each one separately instead of looking at your total inventory. Some items may be unpredictable sellers, and you need more inventory in case of a spike in sales. Others may be very predictable sellers and you can hold less “just-in-case” inventory.
Trim unnecessary expenses. Every dollar you don’t spend stays in your working capital. Review your recurring costs, like subscriptions, software, and vendor contracts, and cancel or renegotiate anything you aren’t using. Look at your biggest line items first, since small cuts there often free up the most cash.
Pro tip: Do a full expense review once or twice a year, and make it a habit. Costs creep up quietly, and a regular check keeps them from eating into your cushion.
Set up a cash reserve or line of credit. You can’t always control when your customers pay or when expenses are due, but you can fully control your credit line. Having working capital financing available will free you up to focus on growing your business without worrying about every big change in inventory or cash.
Pro tip: Get a line of credit in place before you need it. This way you have time to find the best small business funding and a good financing partner so you won’t have to make a fast, suboptimal decision during a crisis.
Working capital can be complex. By following these quick steps, however, you can improve your liquidity and short-term financial health.
FAQs
What is a working capital loan?
A working capital loan is short-term financing that covers everyday business expenses like payroll, rent, and inventory, rather than long-term investments like equipment or real estate. Businesses often use these loans to smooth out seasonal slowdowns or bridge the gap between paying suppliers and getting paid by customers.
How much working capital does a small business need?
Many financial advisors suggest keeping enough working capital to cover three to six months of operating expenses, though the right amount depends on your industry, seasonality, and how quickly customers pay. Businesses with unpredictable revenue or long payment cycles generally need a larger cushion than those with steady, up-front sales.
What is the cash conversion cycle?
The cash conversion cycle measures how many days it takes to turn money spent on inventory into cash from sales. You calculate it by adding days inventory outstanding to days sales outstanding, then subtracting days payables outstanding. A shorter cycle means cash returns to your business faster.
What’s the difference between working capital and profit?
Profit is what’s left after expenses over a period of time, while working capital is your current assets minus current liabilities at a single point in time. A business can be profitable and still run short of working capital, for example when customers pay slowly or cash is tied up in unsold inventory.
Does working capital include long-term assets and debts?
No. Working capital only counts assets and liabilities due within a year. Long-term assets like equipment and real estate are excluded, as are long-term debts like a multi-year loan. The exception is the portion of a long-term loan due within the next 12 months, which counts as a current liability.
Quick note: This is not to be taken as tax, legal, benefits, financial, or HR advice. Since rules and regulations change over time and can vary by location, consult a lawyer or HR expert for specific guidance.
