Working Capital Explained: Definition & Formula

Working capital is the difference between current assets and current liabilities. It indicates your business has enough liquidity to meet short-term obligations and invest in growth.

Did you know: Working capital can also be negative. For example, if you use money from debt that’s repayable five months later to buy land, you’ll end up with negative working capital. We’ll explore this idea in detail later.

To calculate working capital, subtract current liabilities from current assets. Here’s the formula:

Working Capital = Current Assets - Current Liabilities

It’s a simple formula—the calculation is easy, but the concept of working capital feels vague because it doesn’t appear explicitly on the balance sheet. Let’s look at an example that will help you gain an in-depth understanding of how working capital works.

Suppose your balance sheet includes three current assets (cash, inventory, and accounts receivable) and a current liability (accounts payable).

Assume yesterday was day one of business. You purchased 100 t-shirts costing £1,000 on credit from a friend to start your business. Today, you sold 20 of them at £12 a piece—five of them on credit and 15 for cash.

At this point, you have three current assets in your new business: inventory, cash, and accounts receivable.

Here’s what your balance sheet looks like at this point:

Your working capital here is £40 (£1,040 - £1,000).

How does your business have assets and working capital if you’ve invested £0 into your business?

That’s because you financed them partly through current liabilities, and once you made sales, partly through profit.

In the balance sheet above, £1,000 worth of assets are financed through current liabilities, while £40 is financed through profit on sale of 20 units (20 units x £2/unit profit).

To continue running your business, you must introduce additional working capital yourself.

Let’s say you want to bring your inventory level to 100 t-shirts each time you place an order and you’ve agreed on net 30 payments with your friend.

You sold 65 t-shirts during the first month—60 for cash and five on credit—and used the proceeds (£720) to pay your friend.

Your working capital is now £180. Look at your hypothetical balance sheet at this point to understand why:

At this point, the remaining accounts payable become due.

Before you can order 65 t-shirts to bring the inventory level back to 100 units, you’ll need to pay the outstanding £280, and that’s the working capital you need to continue your business.

That’s how your need for working capital keeps increasing as your business grows.

The cash is the entry point for working capital.

Whenever you add new working capital, either from your own funds or through external financing, it will appear as cash first in your balance sheet. It will get converted into inventory or accounts receivable as you use the cash to buy inventory.

Negative Working Capital

Assume that you borrowed money from another friend, to be repaid next month, to buy a warehouse to store t-shirts.

The borrowed money will appear as a current liability on your balance sheet, while the warehouse will appear as a fixed (not current) asset.

When the time comes to repay your friend, you might not have enough cash because you haven’t sold enough inventory to pay for the warehouse.

That’s how your working capital turns negative. Let’s look at the balance sheet for context:

“Maturity matching” can help steer clear of negative working capital. Put simply, maturity matching is the idea of financing short-term assets with short-term financing and long-term assets with long-term financing.

Negative working capital signals a red flag in most cases, but some types of businesses can operate with negative working capital. Take Virgin Atlantic for example. The company, according to its 2023 annual report, has £1,063 million in negative working capital:

The airline collects fares in advance and can delay payments to suppliers, which helps them work with a negative working capital.

As the business grows, so will the list of current assets and current liabilities. You might invest in marketable securities or have prepaid expenses as current assets and deferred taxes as a current liability.

Monitoring financial data and proactively managing working capital is critical to ensuring financial efficiency.

Here’s how you can improve working capital in three easy steps:

Step 1: Centralise All Financial Data in One Place

Scattered business data doesn’t help. In fact, it complicates your analysis and can lead you to make poor financial decisions.

Centralise financial data into one place so it’s easy to track the information you need. For example, you can create a financial dashboard that tracks working capital (and related metrics such as liquidity ratios) in real time.

Financial dashboards make working capital management a lot less daunting. Instead of calculating working capital manually, you can just look at working capital as a figure on your screen and monitor liquidity ratios to determine if your current working capital is sufficient.

For example, you can track the current ratio using your financial dashboard. The ideal current ratio differs among industries, but 1.5 to 2 is generally considered an ideal financial benchmark. If it deviates significantly, it’s best to investigate the reason.

Step 2: Identify Payment Trends and Opportunities

Even if your working capital seems optimal, analyse financial data every month or quarter to look for opportunities that can help free up even more working capital.

Start by looking at the payment trends. Are there any clients that pay late consistently? Are there any early payment discounts you’re not taking advantage of? Is it possible to negotiate terms with a vendor to make them more favourable?

Here’s how these variables impact working capital:

• Late payments: If your accounts receivable balance keeps increasing, you’ll have less cash to buy inventory. If you’re steadily increasing your inventory levels, you’ll need to keep adding more working capital. Instead, see if you can get clients to pay on time (or early with early payment discounts). This frees up cash tied in accounts receivable that you can use to buy inventory.

• Optimise vendor payments: It’s best to pay vendors as late as possible (without harming your relationship with them). Paying late translates to a higher average accounts receivable balance—a current liability that can finance current assets, reducing the need for additional working capital. However, it may be worth paying vendors before time if they offer early payment discounts because it reduces your costs and increases your average cash balance.

An early payment isn’t always a smart move. Let’s say a vendor gives you the option to pay 2% less if you pay within 10 days or pay the full amount in 30 days (aka “2%/10 net 30” in business speak). While 2% sounds like a small discount, the annualised return on taking that discount translates to a sweet 37%.

If you earn a smaller return than 37% from your business or pay a lower rate on your debt, taking this discount makes sense. However, if your return on business is higher (which may be the case for some startups) or you pay a higher interest rate on debt (unlikely), it’s best to skip the discount and invest that money back into business or pay off debt.

Step 3: Monitor and Reduce Unnecessary Expenses

Your business may be leaking cash. Check if you’re overpaying for software subscriptions or office supplies or spending way too much on company retreats. Track your operational and non-operational expenses and see if there’s room to trim any of them.

The more cash your business retains, the less working capital you’ll need to add to your business to sustain and fuel growth.

Suppose you identify the following unnecessary expenses:

• Software subscriptions worth £1,000 a year
• Office supplies worth £500 a year
• Company retreats worth £3,500 a year

Your current working capital is £10,000 (£15,000 in current assets - £5,000 in current liabilities), calculated based on the following average annual balances:

• Accounts payable: £5,000
• Cash: £5,000
• Inventory: £5,000
• Accounts receivable: £5,000

If you cut all unnecessary expenses (totalling £5,000 a year), you can increase your working capital by that amount by:

• Retaining cash
• Maintaining more inventory
• Offering more attractive payment terms to clients
• Reducing the accounts payable balance

Software can become the most powerful tool in your working capital management toolkit if you play your cards right. Let’s discuss how you can use software to efficiently monitor and manage working capital.

Cash Flow Forecasting

Working capital in the form of cash is usable. Accounts receivable, inventory, and other current assets are working capital in its deployed form—not available for any other use until they’re converted back into cash.

That’s why it’s important to forecast your cash position and be mindful of your future cash needs.

Suppose you have £100,000 in cash. You’ve heard from people in your network that a peer company is about to file bankruptcy and is likely to sell inventory at half the cost, which is £50,000.

Using half your cash balance has consequences. You may need to look at various factors. Here are some examples:

• Will you have enough cash left to continue your operations?
• Do you plan to buy fixed assets over the next year or two?
• Do you expect a major economic downturn?

You can slowly build your cash position again as you generate cash from operating activities. However, in the meantime, you need to ensure other areas of business that need cash don’t suffer.

That’s where cash flow forecasting software helps—think of it as a crystal ball to peek into your business’s financial future. If you expect to run into a cash crunch, you can prepare to raise funds via debt or equity, depending on your preferred capital structure.

Process Automation

Automating financial processes using finance software offers three main benefits when it comes to managing working capital:

• Access to real-time and accurate data: Human-driven processes are error-prone. Automate your financial recording and reporting processes to ensure you always have access to accurate data. With real-time data on critical aspects of business such as cash flow, accounts payable, invoicing, and taxes, you’re in a better position to monitor and manage working capital.
• Prevent working capital blunders: Automate your processes to prevent working capital blunders from your end. For example, automating invoices can help generate and send invoices like clockwork so payments never get delayed because you didn’t have time to invoice. Similarly, you can automate payments based on vendor terms so you never get charged for late payments.
• Efficiency gains: Automation saves money—you’ll need fewer employees and resources to generate invoices, record transactions, and prepare financial statements. This leaves you with more cash on hand that you can use as working capital.

Financial Analysis and Reporting

Analysing financial data beyond working capital is also critical because it’s tied to various other parts of your business. Here are examples of areas that impact working capital:

• Financial forecasts: Forecasting your financial statements gives you a clearer idea of your future working capital needs. They also help you preview expected profitability once you induce the needed working capital—if you’re raising funds from investors, they’ll want to look at these forecasts.
• Capital structure: If you need more working capital, you’ll need more capital. The source may be your own funds or external sources. You may have various factors to consider before raising capital. For example, what’s your current debt-to-equity ratio and what will it be after you raise debt capital? Do you have enough cash inflow to service the debt? Will the working capital you deploy generate instant returns or is there a gestation period? If there’s a gestation period, consider long-term debt or equity capital.
• Streamlined reporting: Finance software simplifies complex data into clear, digestible reports you can share with your team, investors, or lenders. Whenever you need to make major decisions related to working capital, you’ll need buy-in from various parties, and real-time reporting can save you plenty of time. Reports are also an excellent way to negotiate better terms with suppliers or secure favourable financing when needed.