Definition:
Working capital refers to the difference between a company’s current assets and current liabilities.
In lay man terms… It is a measure of a company’s short-term financial health and operational efficiency.
Working Capital = Current Assets − Current Liabilities
Where:
Current Assets include cash, accounts receivable, inventory, and other assets expected to be converted into cash within one year.
Current Liabilities include accounts payable, short-term debt, and other obligations due within a year.
The 4 main levers I would like for you to memorize for working capital are cash, inventory, accounts receivable and accounts payable
Why is Working Capital Important?
As an entrepreneur you should be highly fixated on your working capital. If your accountant and/or bookkeeper are not talking about this stuff you need to start questioning the qualification of your service provider.
Your working capital is the pulse of your organization that tells you how healthy you are.
Liquidity & Short-term Solvency – It ensures a company can pay its short-term obligations.
Operational Efficiency – High working capital indicates smooth operations, while low or negative working capital may signal financial distress.
Investment & Growth – Sufficient working capital allows a company to invest in expansion, new projects, and acquisitions.
Creditworthiness – Lenders and suppliers assess working capital to determine a company’s ability to meet obligations.
Types of Working Capital
Positive Working Capital:
When current assets exceed current liabilities, it indicates strong financial health and the ability to expand operations.
Negative Working Capital:
When current liabilities exceed current assets, it suggests potential cash flow problems and difficulty in paying short-term obligations.
Zero Working Capital:
When current assets equal current liabilities, the company operates efficiently but must carefully manage cash flow.
Components of Working Capital
Current Assets:
Cash & Cash Equivalents: Readily available funds.
Accounts Receivable: Money owed by customers.
Inventory: Goods available for sale.
Prepaid Expenses: Payments made in advance for services.
Current Liabilities:
Accounts Payable: Money owed to suppliers.
Short-term Debt: Loans and obligations due within a year.
Accrued Expenses: Unpaid operating expenses.
Working Capital Cycle
The working capital cycle (WCC) measures the time it takes to convert net current assets into cash flow. It involves:
Purchasing Inventory
Selling Products/Services
Collecting Receivables
Paying Off Payables
The working capital cycle formula is: Days Inventory Outstanding (DIO) +
Days Sales Outstanding (DSO) – Days Payable Outstanding (DPO).
This cycle measures the time it takes for a company to convert its inventory, through sales, into cash. A shorter cycle means faster cash conversion and better liquidity. A longer cycle can tie up capital and reduce operational flexibility. This is the metric you must focus on. If you start measuring this KPI each month it will tell you a lot about your organization’s efficiency. This singular data allows you to put in place proper procedures and processes. Having your bookkeeper read numbers off a balance sheet means absolutely nothing.
How to Improve Working Capital?
Speed Up Receivables: Offer discounts for early payments or implement strict credit policies.
Optimize Inventory: Avoid overstocking and use just-in-time (JIT) inventory management.
Extend Payables Period: Negotiate better payment terms with suppliers.
Reduce Unnecessary Expenses: Cut costs that don’t add value to operations.
Example
A company ABC’s balance sheet has:
Current Assets: $500,000
Current Liabilities: $300,000
Working Capital = 500,000−300,000 = $200,000
Since working capital is positive, the company has enough short-term assets to cover its liabilities.
What is the working capital ratio?
Calculating your business’s working capital needs involves determining the right ratio. Your working capital ratio, also called the current ratio.
The working capital ratio shows how much working capital is available for every dollar of current liabilities. Ideally, you want your working capital ratio to be over 1.5, and closer to 2, to give you some room. A higher working capital ratio usually demonstrates a healthier financial position and a better capacity to repay short-term liabilities with short term assets. Working capital is always about the same principle: how you will service your current liabilities with your current assets.
Working capital ratio formula
You can calculate the working capital ratio using the following formula:
Working capital ratio = current assets/current liabilities
Working capital ratio = $120,000 ÷ $70.000 = 1.7 (rounded)
With $1.70 of current assets available for every $1 of current liabilities, ABC Co. has a healthy working capital ratio. Back in the days when I was working with global multinationals as a Director of Finance my finance deck always included a working capital calculation excluding inventory. Inventory is your least liquid current asset compared to cash and accounts receivable. So, if your working capital is 3 to 1, but it’s composed mainly of inventory, I’d be concerned because that means somehow your inventory may not be turning quickly enough or inventory might be obsolete. If it was 3 to 1 but all cash, and quality accounts receivable then you should celebrate this weekend!
If you would like to assess your companies financial well-being feel free to reach out
Remember it all starts with a simple conversation…