What is working capital?

Working capital is key to keeping any business alive. Without it, even the most profitable business may find itself in a financial pickle.

This guide will explain working capital in depth by covering the following topics:

• What working capital is
• The different components of working capital
• What working capital ratio means
• How to calculate working capital
• How to improve it

Working capital refers to the amount of money a company has to run its daily operations and invest in its growth.  In other words, how much cash or assets (valuable items you can convert to cash by selling them) does your business have available? 

Knowing your company’s working capital helps you determine its worth, operational efficiency and current financial health. For example, if you have positive working capital, where your assets outweigh your liabilities (money you owe to creditors, suppliers, banks, etc.), your company should be able to invest and grow. 

On the flip side, if your business has less cash and sellable assets than liabilities, you might struggle to grow or pay back your creditors. In a worst-case scenario, you could go bankrupt. 

Before you can get a complete grasp of how working capital works, you first need to understand the different parts that determine it. We’ve explained them below.

Current assets are either cash you have available now or assets that you can convert into cash within one tax year or operating cycle. You generally use them to run your day-to-day operations. Examples of current assets include:

• Inventory (goods or raw materials)
• Accounts receivable (money customers owe you)
• Cash equivalents like short-term bonds
• Short-term investments

Your assets will also be separated into:

• Tangible assets – these are fixed (physical) operational resources and are often essential for small businesses. Examples of tangible assets include inventory, property and equipment.
• Intangible assets – these refer to nonphysical resources, such as your brand name, storage facilities, patents, established processes and copyrights. 

Simply put, current liabilities in business are funds that you owe short-term, usually within a month, quarter or year. This could be any money you need to pay other people, banks or businesses. Current liabilities can be an actual cost, like bills or contracts you have to pay, but also a potential cost, such as a possible legal dispute that you have to budget for.

Current liabilities can be financial obligations like:

• A business loan
• A mortgage on a business property
• A rent payment on a business premises
• Any other bank debt, such as overdrafts or charges on an account
• Supplier contracts you owe
• Other accounts payable entries, such as invoices for contractors’ work
• Other financial obligations, such as paying wages or freelancers
• Taxes due to be paid to HMRC
• Utility bills and monthly insurance payments

Your working capital ratio describes the balance between your company’s current assets and liabilities. Let’s look at an example of what this could look like:

If a company’s current assets amount to £30,000 and its current liabilities are £10,000, the current working capital ratio is 3:1. 

Calculating your working capital is a fairly straightforward process where you compare your company’s current assets to its current liabilities. As long as you know what your assets and liabilities are and how much they amount to, you should be able to find out your working capital reasonably easily. 

To calculate your working capital, you divide your current assets by your current liabilities. The formula is as follows:

Working capital ratio = current liabilities ÷ current assets

If you get a number above 1, it means you have positive working capital and that your assets outweigh your liabilities. A number below 1 means your liabilities exceed your assets and that you might struggle to pay your dues and invest in company growth. 

Generally speaking, the higher the number, the better your business is doing financially. 

A company’s working capital cycle (or WCC) describes how long it takes for the business to turn current assets and liabilities into cash. The WCC metric helps pinpoint where your capital is tied up in running your business before earning a return on investment. 

Reducing your WCC would help improve your company’s efficiency since you’ll transform assets and liabilities into cash faster. As a result, you’ll clear your debts quicker and release more money sooner to reinvest in the business. 

Working capital management refers to how well you manage your working capital and your WCC. How well do you keep cash moving within your business?

Every business needs to find a balance between collecting money it is owed and paying off debts it owes to others. As a business owner, you need to be clever about how you use your assets to make sure you have enough to cover your company’s financial obligations. 

Efficient working capital management doesn’t just happen but requires highly organised accounting and closely monitoring your current working capital. You need to keep on top of any changes and adapt your business to get maximum use out of the working capital you have. 

In a small business, you mainly need to keep track of your assets and liabilities and regularly calculate your ratio to ensure your liabilities don’t exceed your assets. 

You can improve your working capital management in the following ways:

• Shortening your invoice credit time (how long customers have to pay your invoice)
• Credit checking potential customers (to make sure they’re able to pay)
• Managing inventory better (to make sure you buy and stock more popular products)
• Negotiating better payment terms with suppliers

Keep track of your working capital easier by managing all your financial data in one place. The Countingup app and business current account comes with free built-in accounting software that automates the time-consuming aspects of bookkeeping and taxes. You can view real-time insights into your business’ finances, profit and loss statements, tax estimates and create invoices in seconds. 

You can also share your bookkeeping with your accountant instantly without worrying about duplication errors, data lags or inaccuracies. Seamless, simple and straightforward!

Download the Countingup app to apply for your business current account in minutes. All you need is proof of ID and a selfie. Find out more here.