What Is Working Capital and Why Does It Matter?

Working capital is an important part of the financial foundation of your business. It’s crucial for funding day-to-day operations, supporting growth strategies and navigating uncertainties. Ensuring you have enough working capital can help you take advantage of opportunities and navigate the ups and downs of running a business.

What Is Working Capital?

Working capital is a measure of a company’s liquidity. It measures the difference between your current assets and current liabilities. Essentially, it’s what keeps your business running. It helps ensure that you have enough cash on hand to meet immediate business needs such as payroll, utilities and vendor payments.

Why Is Working Capital Important?

Working capital is important because it helps fuel your business’s day-to-day operations — but it’s also important for long-term growth. When you have a sufficient amount of working capital, you can invest in growth strategies, weather seasonal fluctuations and handle any challenges you may face.

Good working capital management is about more than just keeping the lights on. It’s also a signal of financial health and operational efficiency. It’s a good sign to potential lenders or investors that your business is ready to grow.

What Is Working Capital Used For?

Working capital has many different uses. It’s a source of funds for everyday expenses and is essential for running and expanding your business.

Here are few things working capital is used for:

• Buying inventory.
• Paying wages.
• Purchasing supplies.
• Paying bills.
• Settling short-term debt.

What Is Net Working Capital?

When talking about working capital, most people are referring to “net working capital.” Working capital only refers to your company’s current assets, while net working capital measures your current assets minus your current liabilities. This gives you a more accurate measure of the cash your company has available.

How to Calculate Working Capital

To calculate your net working capital you simply need to subtract your current liabilities from your current assets. You can find these listed on your balance sheet. Keep in mind that “current” typically means within one year or accounting period. You may also see them referred to as “short-term assets” and “short-term liabilities.”

Net Working Capital = Current Assets – Current Liabilities

Examples of current assets:

• Liquid assets such as cash or cash equivalents.
• Short-term investments (expected to be converted into cash within one year).
• Accounts receivable.
• Inventory.
• Raw materials.

Examples of current liabilities:

• Accounts payable and other bills.
• Short-term debts.
• Wages.
• Taxes.

The working capital formula is fairly simple, but it can provide a quick insight into the health of your business and your working capital needs. A positive working capital figure shows that you have more than enough liquidity to cover your operating expenses. A negative working capital can signal that you need to take a closer look at your finances.

You should also keep in mind that working capital does not consider things like long-term liabilities or long-term debts. Those are considered when calculating fixed capital.

Working capital ratio

Another way to look at working capital is to calculate your working capital ratio. This is a widely used financial metric that can help you further understand your working capital. To calculate your current ratio, divide your current assets by your current liabilities.

Working Capital Ratio = Current Assets / Current Liabilities

A ratio above one means you have a positive working capital while a ratio below one indicates a negative working capital. A good working capital ratio is typically considered to be anywhere between 1.5 and 2.

Positive vs. Negative Working Capital

Positive working capital. A positive working capital generally means you have enough cash to cover your company’s short-term obligations. This can indicate good financial health and good financial management.

Negative working capital. Negative working capital arises when a company’s current liabilities exceed its current assets. This situation may raise eyebrows because it suggests that a company might not have enough liquid assets to cover its short-term obligations. But there are some situations where it’s acceptable. For example, for businesses that operate in industries with fast inventory turnover (they sell their inventory before they need to pay their suppliers), a negative working capital isn’t necessarily a bad sign.

What Is the Difference Between Working Capital and Cash Flow?

While cash flow and working capital are closely related, they are different. Cash flow measures the amount of cash coming in and flowing out of your business within a set period of time. Your company’s working capital on the other hand, strictly measures your company’s ability to meet short-term obligations.

The main difference is the story they tell about your business. Your cash flow provides a more dynamic view of your business’s finances as a whole, while working capital offers a more narrow view. Both metrics are essential for understanding and managing your company’s financial health.

How to Increase Your Working Capital

Boosting your working capital can make a big difference for your business. It usually involves implementing a range of different strategies tailored to your business needs.

Streamline your operations. Looking for ways to improve your operations can save your company money. Try to find ways to reduce waste, increase efficiency or speed up your cash cycle.

Improve your inventory management. Try to align stock levels with demand so you can avoid overstocking or selling out of an item. You can use past data to forecast what you may need during each season.

Negotiate with your vendors. Talk to your vendors to try and negotiate better payment terms. It can help if you have a good business credit score or a strong history of repayment with the supplier.

Consider financing. If you find that you need additional working capital, you may want to consider working capital loan options like a short-term loan or line of credit. These can help get a quick injection of cash into your business. You can also consider options like a merchant cash advance or invoice factoring.