Working capital for small businesses: your five-minute guide
Working capital is the money your business has available for daily operations. It’s calculated by subtracting liabilities — such as wages and taxes — from your assets, including cash and inventory.
Managing your working capital effectively can help ensure your business stands the test of time.
Sufficient working capital enables your business to cover everyday costs, such as rent and bills. It’s essential to your company’s survival, so here’s what you need to know to keep your working capital on an even keel.
Key takeaways
Your company’s working capital is the difference between its current assets and liabilities
Positive working capital means the company can pay its bills and invest for future growth. Negative working capital means its liabilities exceed its assets
Too much working capital can suggest a business has excess inventory or is not taking advantage of investment opportunities
What is working capital?
Working capital is the money you need to operate your business from day to day.
It’s an important part of business finance. If there’s not enough working capital — or liquid assets, such as cash — to cover costs, your company will struggle to survive if anything goes wrong.
The aim is to have enough working capital to pay essential costs such as supplier invoices and utility bills, even if clients fail to pay you on time.
Doing so can help you to qualify for business credit cards and loans.
It’s also useful to know how much working capital you have when writing a business plan or taking decisions, such as whether to buy new equipment or take out a business loan.
If you are involved in business budgeting, it’s important to have a grip on the working capital situation.
How can I calculate my working capital?
The components of a company’s working capital are its current assets and liabilities.
Current assets include:
Cash, such as the business’s bank balance
Short-term investments (that can easily be sold)
Accounts receivable, such as unpaid customer invoices you expect to collect soon
Inventory, including raw materials, work in progress and finished goods
Prepaid expenses, such as insurance or rent paid in advance
Current liabilities include:
Wages and salaries owed to employees
Taxes, including VAT, National Insurance and PAYE
Accounts payable (e.g. unpaid supplier invoices)
Accrued expenses such as utility bills
Bank overdrafts and any other short-term borrowing
Loan repayments and interest due within the next 12 months
The classic formula for calculating working capital is:
Current assets - current liabilities = working capital
Working capital example
A manufacturing company has current assets worth £160,000 and liabilities totalling £110,000.
This results in a working capital value of £50,000.
£160,000 - £110,000 = £50,000
What is a good working capital ratio?
A £50,000 difference between assets and liabilities might be more than enough for one company but could leave another business short.
That’s where the working capital ratio comes in.
It tells you how many times your business could pay off its current liabilities using its current assets.
Again, it’s a very simple calculation.
Current assets divided by current liabilities = working capital ratio
In the example above, this would equate to:
£160,000 / £110,000 = a working capital ratio of 1.45
That’s good news, as the aim is to have a working capital ratio of more than one. Anything less indicates the business lacks the cash to service short-term liabilities while disposing of less liquid assets, such as properties, in times of trouble.
How does working capital affect cash flow?
Working capital and cash flow are closely linked.
Cash flow refers to the money moving in and out of a business over a set period, while working capital is the cash available to cover daily expenses if incoming cash isn’t enough.
Keeping these figures balanced via a cash flow forecast, is essential when budgeting.
For example, if a business loses a major client and revenue drops, or it faces an unexpected expense like a roof replacement, cash outflows may suddenly spike. In such cases, the business would need to rely on its working capital to cover operating costs.
💡 Editor insight: Cash flow is taking a toll on SME leaders’ focus and decision-making
How can I improve my working capital?
The easiest way to improve working capital is by increasing current assets and reducing liabilities.
Ways to boost current assets include:
Chasing overdue invoices and encouraging customers or clients to pay more quickly
Negotiating shorter payment terms
Reducing unnecessary spending
Selling old or surplus inventory
Avoid holding onto more stock than needed
Ways to reduce current liabilities include:
Paying off debts
Negotiating longer payment terms with suppliers
Securing more favourable lending terms
Refinancing short-term borrowing into longer-term financing where appropriate (just make sure you don't end up paying lots more in interest)
Cancel any services or subscriptions you no longer need
Since working capital and cash flow are closely connected, one way to improve working capital is by shortening your cash flow cycle. For instance, you could reduce your payment terms from 30 days to 15 days.
Better stock management — only buying as much as you need when you need it — can also help.
Remember, though, that too much working capital is not always a good thing.
You need enough to ensure your company can survive any glitches, such as a cash flow management problem. But good business financial planning means using surplus cash to grow your business and profits, rather than leaving it in the bank.
About Jessica Bown
Jessica Bown is an award-winning freelance journalist and editor who has been writing about personal finance for almost 20 years.
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