Working capital is essentially a business’ current assets minus its current liabilities.
Yet achieving a healthy flow of working capital isn’t always as straightforward as it sounds. In this guide to working capital, we’ll whizz through some of the key terms and teach you how to work out your own business’ working capital ratio.
What is working capital?
Working capital is essentially a business’ current assets minus its current liabilities, or in other words the operating liquidity that is available to a business after its financial obligations have been met.
Why is working capital important?
Having a healthy working capital ratio typically signals that a business can use its current assets to pay off its current liabilities. Businesses with a ratio that exceeds 1 can convert its assets into cash quicker.
Generally speaking, the higher the ratio, the more likely it is that the business is able to fund day-to-day operations and meet its debt commitments and short-term liabilities.
Creditors and investors often see companies with a working capital ratio of under one as more risky because it can suggest that they might not be able to meet debt requirements.
A ‘current ratio’ of under one is referred to as ‘negative working capital’.
How do I calculate working capital? What is a working capital ratio?
To work out your working capital, subtract the sum of your current total liabilities from the sum of your current total assets. So, WORKING CAPITAL = CURRENT ASSETS - CURRENT LIABILITIES.
For instance, if your balance sheet displays assets totalling £100,000 and total liabilities of £40,000 you’re working capital is…you guessed it: £60,000. For clarity, ‘current’ means ‘within the next 12 months’, unless you operate using a different accounting period. Your current assets are the assets that can be turned into cash within a year and current liabilities are debts and other obligations that need to be paid within the next year.
What is a working capital ratio?
A working capital ratio is the ratio between the amount of current assets to current liabilities. You can work it out by dividing total current assets by total current liabilities.
Let’s take our previous example of £100,000 assets £40,000 liabilities.
The ratio would be 100,000 / 40,000 = 2.5. Some people also use the term ‘working capital ratio’ to describe the working capital amount, e.g. £60,000, however this isn’t the correct usage.
Which assets and liabilities are included in working capital?
Current assets tend to be the things that generate money for a business whereas current liabilities are the things a business has to pay for. Let’s take a look at a few examples.
Current assets usually include:
- Cash in savings accounts
- Accounts receivable
- Expenses (pre-paid)
- Investments (short-term)
Current liabilities usually include:
- Rent on premises
- Accounts payable
- Accrued expenses and income tax
- Utility costs
Positive vs negative working capital
Positive working capital
If a business has positive working capital, it means that they have more assets than liabilities, with a working capital ratio of more than 1.0.
This generally means that the business can pay its debt from the money it makes and can turn its assets into cash within 12 months. Of course, working capital can fluctuate seasonally depending on which sector the business is operating in.
Achieving positive working capital doesn’t mean everything is perfect. For example, if a business has a lot of cash and a high positive working capital ratio it might be a signal that it should start investing and growing the business (if that’s the route they want to take).
Negative working capital
If a business has negative working capital, it has more total liabilities than assets and a working capital ratio of below 1.0. In other words, something is amiss and improvements must be made.
There are a number of reasons as to why a business may suffer from negative working capital. Perhaps it isn’t selling its products or services at a competitive price or is waiting too long for customers/clients to pay. Maybe it’s paying for unnecessary expenses. Or it could be something else entirely!
That said, what is deemed a ‘normal’ working capital ratio for one business might be completely different for another. As with positive working capital, how worrying negative working capital is depends to some extent on the industry the business is operating in and other factors.
How to improve working capital
Finally, how can a business improve its working capital ratio?
It may want to begin by looking at its business model to see if it can cut expenses and come up with alternative approaches to doing business that don’t require as much working capital.
It could also:
- File invoices on time
- Credit check new customers/clients
- Limit expenses if possible
- Collect outstanding invoices on time
- Boost sales revenue
- Avoid stockpiling
- Explore invoice finance, equipment leasing and cash flow finance
Leasing equipment instead of buying it outright enables businesses to gain access to the latest technology without having to invest large sums of money regularly. Invoice finance is a method of borrowing money based on what company’s customers owe. Instead of waiting for long periods for invoices to be paid, lenders will provide the business with the majority of the value straight away.
Working capital loans
For some businesses, especially startups and SMEs, working capital finance can provide the necessary cash flow boost that is needed to create breathing space and provide security for the short-term.