Working capital refers to the resources available for you to use in your day-to-day business operations and includes cash, accounts receivable, inventory, and securities.
The formula for calculating working capital is:
Current assets – current liabilities = working capital
Working capital is critical to the success of your business. Without working capital, you cannot operate, as it provides the free cash flow required to purchase inventory, pay employees and contractors, lease your space, and more.
Working capital is used every day that your business is in operation. It’s used to stock your shelves, pay your team, and otherwise operate your business. Working capital may also be used by lenders and investors as a measure of the liquidity, efficiency, and the financial health of your business.
Working capital can come from your operating, financing, or investing activities. You can learn more about each of these sources in The Ultimate Cash Flow Guide.
Cash flow measures the funds flowing in and out of your business over a specific period of time, while working capital is the sum equal to your current assets minus your current liabilities.
Without working capital, you do not have the cash flow to pay your company’s short-term expenses. Keeping your cash flow positive is the key to ensuring you always have enough working capital to operate your business and meet your obligations to creditors, employees, and clients.
As a business owner or manager, you can calculate working capital using the figures provided to you on your company’s balance sheet.
Your cash flow statement shows the amount of cash flowing in and out of your business from operating, financing, and investing activities over a specific period of time. It’s a critical financial document, but you won’t find working capital here. To learn more about your cash flow statement, keep reading here.
Working capital is one of the easiest calculations to work out from your balance sheet. Simply subtract your current liabilities from current assets. As a rule of thumb, experts like to see that a company has enough working capital to pay all of its expenses for one year.
Your working capital ratio, or current ratio, shows how your current assets stack up against your current liabilities. A ratio of 1.0 indicates that you may be facing imminent financial difficulties, while a ratio of 2.0 demonstrates greater short-term liquidity and is an indicator of better financial health. The working capital ratio formula is:
Current assets ÷ current liabilities = working capital ratio
Working capital management is closely linked with cash flow management. Together, these disciplines help to ensure that you always have enough liquidity and cash flow to meet your financial obligations and grow your business. Read Cash Flow Management Basics to learn more.
Small and medium-sized businesses tend not to have large reserves of liquid assets. In fact, too much working capital isn’t necessarily a good thing (more on that below). Taking a proactive approach to managing your working capital helps ensure that you are making informed financial decisions for your business.
As a rule of thumb, you should have enough working capital to pay all of your bills for one year.
Positive working capital means you have more current assets than liabilities, and can cover your financial obligations over the next 12 months.
Negative working capital means you have more current liabilities than assets. For example, a construction contractor may find themselves in a position of negative working capital when beginning a new project, due to the large outlay of cash required for purchasing materials and contracting vendors. It’s critical to limit periods of negative working capital as much as possible.
Absolutely. If you hang on to a large amount of positive working capital (greater than one year’s worth of liabilities), investors and lenders might actually see this as a drawback. Those funds could be better spent investing in the growth or improvement of your business.
You can increase your working capital through operations, financing, or investing activities by filing and collecting invoices, reducing expenses, increasing sales revenue, reducing inventory volume, and more. Learn more in How to Increase Your Working Capital and Liquidity.
Working capital provides the cash you need to operate, so staying on top of it is one of the most beneficial things you can do for your business. Collect payments as quickly as possible to keep cash flow positive. Avoid using working capital to finance fixed assets like equipment; deploy short or long-term financing here, instead. Don’t be afraid to borrow to invest in your business, and make sure you’re maximizing the value of your accounts receivable by using a tool like invoice factoring to convert working capital to free cash flow as needed.
Cash flow is the measurement of net cash and cash equivalents flowing in and out of your business over a specific period of time. Cash flow tells management, investors, and others whether your company is able to pay its current liabilities. It’s an important determinant of your company’s financial health.
Invoice factoring is an effective, inexpensive method of improving liquidity by speeding up your invoice collection cycle and putting money you’ve already earned to work for you sooner. It allows you to purchase inventory, buy equipment, make payroll, and otherwise fund critical business operations even while extending attractive credit terms to your clients. Here’s how invoice factoring works.
How’s your rich uncle doing? If (like most entrepreneurs) relying on a benevolent benefactor isn’t an option for you, you’ll need to proactively plan to keep your working capital and cash flow positive to avoid financial crises. You can learn more about cash flow management here. Then, view our pricing to see how inexpensive it is to put this innovative financial management strategy to work for your business.