What is working capital?

Working capital, the difference between your company’s current assets and liabilities, is essential for operating a start-up business, funding growth and expansion, and preventing it from failing.

Getting to grips with working capital from day one will help to make your business more resilient and stable during tough times, such as rising inflation and pressures on the cost of living.

What is working capital?

Working capital is the money you have available to fund your business’s day-to-day operations over the next 12 months.

It’s the difference between your business’s current assets and current liabilities.

Current assets are the financial benefits you expect to convert into cash within the next year. They include:

• cash in current and savings accounts
• accounts receivable
• stock and inventory
• short-term expenses
• pre-paid expenses.

Current liabilities are debts you expect to pay within the following year. They include:

• rent, utilities, and supplies
• accounts payable
• accrued expenses
• accrued income taxes
• dividends payable.

Why is working capital important?

Working capital is critical to your business because you need enough money to fulfil your financial obligations, such as paying employees and suppliers.

Effective management of working capital helps to make your business more resilient, particularly during tough economic times.

Working capital is essential for businesses looking to grow.

A larger company has an increased customer base and a bigger need for suppliers, so you need to be able to pay your expenses until your customers pay you.

How to calculate working capital

To calculate your working capital, subtract your total current liabilities from your current assets.

The formula is:

Working capital = current assets – current liabilities

For example, if your business has £500,000 in current assets and £400,000 in current liabilities, your working capital is £100,000.

Your working capital can be positive (your business has more money coming in than going out) or negative (your business has more money going out than coming in).

To calculate your working capital efficiency and how well your business will be able to handle tough financial or economic times, you need to work out your working capital ratio.

To do that, divide your current assets by your current liabilities.

The formula is:

Working capital ratio = current assets ÷ current liabilities

For example, if your business has £500,000 in current assets and £400,000 in current liabilities, your working capital ratio is 1.25.

A ratio of between 1.2 and 2.0 is considered good, whereas a ratio below 1 indicates your business faces potential financial problems and may not have enough money to pay your bills.

A high working capital ratio isn’t necessarily positive.

It might indicate that your business is not investing enough of its cash in growth.

How to determine how much working capital you need

The amount of working capital you need depends on various factors, including:

Type of business

The type of business you operate influences how much working capital you need.

For example, retail businesses typically require a significant amount of working capital because they need to buy stock well before selling it.

In contrast, software companies have fewer requirements for working capital as they do not deliver a physical product.

Your attitude to growth also has an impact on your working capital.

A business owner looking to scale will require more working capital than one happy to keep their company at its current size.

Seasonality

Some businesses, such as tourism companies, have seasonal demands so will require more working capital when demand is high.

You need to predict your most and least profitable months based on the type of business you are running.

This will allow you to be prepared with enough working capital for when business is slower.

Length of operating cycle

An operating cycle, also known as the cash conversion cycle, is the time it takes for a business to turn inventory or stock into sales.

The length of this cycle will dictate how much working capital you need.

How to manage your working capital

To improve your working capital, steps you could take include:

Inventory management

Better management of your inventory can improve your working capital.

Unsold inventory sitting in storage eats into your liquidity.

It adds extra costs such as insurance, and you risk price changes and inventory deterioration.

To avoid this, keep the minimum possible stock without impacting your sales.

You could also adopt the just-in-time (JIT) inventory system, which involves receiving materials from a supplier only at the point they are needed.

This process cuts expenses as you only pay for the exact resources required. Warehouse costs are also reduced.

Inventory management software can help to better track your orders, deliveries, and sales to avoid overstocking.

Reduce your expenses

It might be a good idea to analyse your expenses to see if you can free up more working capital.

By monitoring regular subscriptions for services such as software it’s possible to highlight any that are no longer needed for your business.

Other ways to cut expenses include reducing travel costs by conducting meetings virtually rather than in person and outsourcing services such as accounting, human resources, and marketing instead of employing your staff.

Read more about reducing costs.

Negotiate better terms with suppliers

Renegotiating with suppliers can improve working capital.

You could regularly review your supplier contracts to see if you can get a better deal.

You might be able to get free or reduced delivery for bigger or more regular orders as well as discounts for early payments.

Ensure that you stick to suppliers’ terms and conditions to avoid harming your credit standing and reducing your chance of securing finance in the future.

Working capital finance

Obtaining external funding can help to augment your working capital.

You should seek independent advice when deciding which funding solution is best suited to your company.

Your options include:

• Working capital loans: Normally lent on a short or medium-term basis, working capital loans usually require assets as security.
• Overdrafts: A line of credit that allows for the withdrawal of more than the funds a business has available in its account.
• Invoice finance: Also known as invoice discounting and factoring, this type of funding allows a business to use its invoices and accounts receivable as security for funding.
• Asset-based lending: This is where a business uses assets it already owns, such as property and machinery, as security against finance.