Working Capital: Why It’s Important and How to Increase It

You already know how important your cash flow is to your business’s finances. But are you keeping an eye on your working capital?

Cash flow and working capital are similar concepts, but they’re not interchangeable. Like cash flow, your working capital is a useful tool for gauging your business’s financial health.

What Is Working Capital?

Working capital (also known as net working capital) is the amount of money your business has available to cover daily operating expenses such as payroll, lease and utility payments.

From an accounting standpoint, working capital is the difference between your business’s current assets and its current liabilities. Here’s what those accounting terms mean:

Current assets. A current asset, also known as a short-term asset, is a liquid asset. That means it can be liquidated into cash within the next 12 months if necessary. Current assets include cash and cash equivalents (for example, treasury bills and money market funds) and other short-term assets, such as accounts receivable, inventory and prepaid expenses.

Current liabilities. These are any short-term liabilities or financial obligations payable within the next 12 months. For example, your accounts payable—which is what you owe your suppliers and vendors—is a current liability. A business loan is typically a long-term liability, but the monthly payments you make on the loan are categorized as a current liability.

How To Calculate Your Working Capital

To calculate your working capital, you need to know your total current assets and total current liabilities. You can find these numbers in your most recent balance sheet. If you don’t have a recent balance sheet prepared, you’ll need to add up all of your current assets and current liabilities separately to get the numbers you need.

The formula for calculating working capital is simple:

current assets – current liabilities = working capital

Plug your own current assets and current liabilities into this formula to determine your net working capital.

Here’s an example. Let’s say you have current assets of $20,000 in accounts receivables, $20,000 in inventory, and $20,000 in cash, for a total of $60,000 in current assets.

You have current liabilities of a $5,000 lease payment, $20,000 in payroll costs, a $10,000 tax installment, and $5,000 in accounts payable, for a total of $40,000 in current liabilities.

Using these numbers, you would have working capital of $20,000 ($60,000 – $40,000 = $20,000).

Ideally, your working capital will be a positive number, which means you have enough money to cover your day-to-day operating expenses. If your current liabilities are greater than your current assets, you’ll have negative working capital—meaning you don’t have the funds to pay short-term debts as they come due.

Temporary factors, such as a significant cash purchase of a long-term asset, can result in negative working capital in the short-term. Negative working capital every once in a while might not be an issue. It can become a concern, however, if you’re seeing negative numbers consistently.

Your Working Capital Ratio

Also known as the current ratio, the working capital ratio is a financial ratio that helps you assess your business’s liquidity. To determine your working capital ratio, take the same figures you plugged into the working capital equation and compare them in a ratio format.

Use the following formula to calculate your working capital ratio:

current assets ÷ current liabilities = working capital ratio

Your result will be a decimal. For instance, from the example above, you would have a working capital ratio of 1.5 (60,000 ÷ 40,000 = 1.5).

A working capital ratio of between 1.5 and 2.0 indicates your business is in good financial health. It means you have the funds to cover your short-term liabilities as they come due, and you also have enough working capital to provide a financial cushion if your business experiences a bad month.

If You Have a Low Working Capital Ratio

You don’t want to see your working capital ratio fall below 1.0, since this means you have more current liabilities than current assets—which can have disastrous consequences when it comes time to pay your monthly bills.

While a low working capital ratio can be manageable in the short term, over time it signals a business’s inability to meet its liability obligations. So if you find yourself looking at a low working capital ratio consistently, it might indicate a problem with your current business model.

If You Have an Excessively High Working Capital Ratio

A working capital ratio that’s too high isn’t necessarily a good sign. It could mean your business has money laying around that isn’t being put to good use. This might be a sign to assess your current assets to see if you have funds you could invest in something that would give your business a better return.

For example, let’s say you have $120,000 in current assets, $50,000 cash in your business bank account and $25,000 in current liabilities. This means you have a working capital ratio of 4.8.

This ratio is quite high. With $50,000 sitting in your bank account, you may want to consider putting some of this idle cash to use by investing it.

Working Capital vs. Cash Flow

People sometimes refer to cash flow and working capital as identical concepts, but they’re actually very different.

Like working capital, cash flow is an important measure of a business’s financial health. It’s all about the flow of cash (and cash equivalents) in and out of your business. You can find the numbers relevant to your cash flow in your business’s cash flow statement.

Cash flow refers to the amount of cash your business generates in a specified time period (usually 30 days). It’s not the same as net profit, since cash flow doesn’t take into account any liabilities you have to pay. Cash flow also includes all money your business has coming in, such as loan proceeds.

Working capital, on the other hand, takes your short-term liabilities into account. It compares these liabilities with your short-term assets so you can see if your business is able to meet its monthly financial obligations.

High working capital often comes with a positive cash flow, but not always. Current assets and current liabilities can impact working capital, but not necessarily cash flow.

An Example

Let’s say Ace Corporation sells a high-end business software system for $250,000. By selling just a few systems a month, it sees a positive cash flow from the high revenues each sale generates.

But during the product development stage, the company took out several large loans, resulting in a heavy debt load and monthly loan payments totaling $300,000. These payments increase its current liabilities from $150,000 to $450,000.

The result: Despite a positive cash flow, high monthly debt payments result in low working capital.

Tips for Increasing Your Working Capital

If your working capital is lower than you’d like, here are some ways you may be able to increase it.

• Reduce costs. Lowering your day-to-day expenses will reduce your current liabilities. You could take advantage of early payment discounts offered by vendors, or eliminate any unnecessary subscription services.
• Increase prices. This increases your cash on hand. Of course, a price increase will only be an effective means of increasing your working capital if it doesn’t hurt sales.
• Effective inventory management. Inventory can be tricky: If you don’t have enough to meet demand, you miss out on sales. If you have too much, your funds sit idle in inventory that’s not moving. Implementing an effective inventory management system can help you find the sweet spot between the two.
• Invoice earlier. If you typically wait until the end of the month to send out your invoices, consider changing to a system where you bill your customers as soon as you’ve delivered the product or rendered your services. The earlier you bill your customers, the quicker you’ll collect payments.
• Negotiate with your vendors. Consider reaching out to negotiate better payment terms. For example, working out a net 45 payment arrangement instead of net 30 can have a significant impact on your working capital by giving you an extra 15 days of breathing room to pay that vendor’s bills.
• Look into working capital financing. Many businesses opt for a line of credit or a working capital loan to help them meet temporary shortfalls in working capital. A business line of credit can be a helpful credit tool, as you only incur the costs of borrowing from it when you need it.

By monitoring your business’s working capital and its working capital ratio, you can gain a useful snapshot of your business’s current financial health as you plan for the future.

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