Working capital – or net working capital – is the cash your business needs to pay its bills and keep operating successfully.
“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.
Let’s 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.
What is operating working capital?
Operating working capital (OWC) measures the liquidity of your business. It refers to the amount of investment needed to fund your company’s day-to-day operations, including buying and selling inventory, paying suppliers, and receiving payment for goods and services.
A high OWC is good for short-term financial health because it means your business has enough cash to negotiate better terms with suppliers and invest in stock to meet customer demand.
Working capital and the balance sheet
To accurately report on working capital, you will need to carry out a financial analysis of your company’s balance sheet, which shows all of the company’s assets and liabilities, by category, in both the short and long term.
This allows you to understand whether your business has a positive or negative working capital, and to make better-informed business decisions based on a better understanding of your long- and short-term financial health.
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 liabilities (expenses and debts), while a negative number means you don't.
The working capital formula is:
Working Capital = Current Assets - Current Liabilities
Example 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 is a key difference. Cash flow offers a snapshot of the money moving into and out of your business at a given point in time, while working capital considers liabilities and assets that will have an impact on your business across the financial year.
Unlike working capital, cash flow doesn’t reveal how effectively you’re managing your finances or how much leeway you’ll have if you run into problems with your supply chain, for example.
Because working capital considers money coming in (accounts receivable) and money you owe (accounts payable) alongside other liabilities, it provides a clearer idea of 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 company's working capital requirements will help ensure your business is able to sustain itself and, ideally, grow. It helps you to ensure there's enough money available to pay your suppliers, employees, rent, and other overheads, while also having surplus cash for emergencies and new opportunities.
Knowing your level of working capital management 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 helpful figure when managing cash flow and forecasting how much cash you’ll need is the working capital cycle.
The working capital cycle is the amount of time that passes between using your cash to purchase stock and receiving money for the resulting sale. In other words, it's the length of time 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 the working capital ratio?
The working capital ratio – or current ratio – shows the relationship between how much your company has in assets versus in liabilities, and will typically give you a figure between 0.5 to 3.0.
Working Capital Ratio = Current Assets/Current Liabilities
A figure of 1 or more signifies that your assets outweigh your liabilities; a figure less than 1 signifies the reverse. While it's not ideal for your liabilities to outweigh your assets, too high a figure suggests you're not investing when you could be.
In some cases, you might want to calculate a more targeted ratio that only looks at assets available to you in cash, or that can be quickly converted into liquidity.
In this case, you would calculate working capital ratio as above, but exclude any non-liquid assets. This is known as the quick ratio.
What is working capital finance?
Working capital finance is when a business borrows money to plug a working capital gap. “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 sectors such as tourism, working capital finance can be particularly beneficial in managing peaks and troughs. .
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.
Your receivables (or debtors)
Try to maximise your chance of receiving payment on time from clients and customers. This could include discounting orders that are settled quickly, sending automated email reminders, and giving shorter payment terms whenever possible.
Your stock
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.
Your liabilities (payables or creditors)
The more time you have to pay your suppliers, the longer you get to keep 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.