Working capital: What is it, how to calculate it, and why it’s important

Getting to grips with the money side of running a small business requires a degree of mental multitasking. An entrepreneur has to consider all the everyday incomings and outgoings, while thinking about future revenues and overheads too.

One key concern when managing your small business finances is something called working capital. Knowing how to calculate working capital is important for making sure your business can pay its bills on time, and that you’re able to grab new business opportunities when they come up.

In this guide, we take a closer look at working capital, breaking down this essential money metric for your enterprise. We’ve included an easy-to-understand definition of working capital and insights into why it’s so important for your business.

As well as answering the question “What is working capital?”, this guide also talks through some smart moves for boosting this metric, so you can improve your business operations and make sure your business can keep on running smoothly into the long-term.

What is working capital?

Let’s start with a simple working capital definition: it is the difference in value between your current assets and current liabilities.

The word “current” in this definition typically refers to an entire year, so working capital indicates a company’s short-term financial health, representing the money a business has on hand to meet its commitments and operational needs over the next 12 months.

But working capital, a phrase often used interchangeably with net working capital, doesn’t just show you if you’ve got enough money to keep ticking over and cover what you owe. 

It can also help inform other essential business activities – everything from deciding upon pricing strategies and how to advertise your business, to conducting a SWOT analysis for small business.

Understanding working capital isn’t just for owners of established businesses. Whether you’re just starting to explore side hustle ideas, considering how to make money online, or setting up a limited company for the first time, it’s important to know how much cash you’ve got at your disposal from day one.

How to calculate working capital

Figuring out your business’s short-term money situation starts with understanding how to calculate working capital. There are a few main ways to see if you’ve got enough in the tank:

• Working capital formula

• Working capital ratio

• Quick ratio

Working capital formula

The working capital formula provides a straightforward way to check the financial health of your business. 

Here’s what it looks like:

Working capital = current assets – current liabilities

For example, if a business has £50,000 in current assets and owes £35,000 across the next 12-month period, its working capital is £15,000. 

The working capital calculation tells you what you’ve got to play with – a positive number generally means that you’re set up to cover your bills and invest in growing your business, for example by implementing new technology to optimise workflow.

Working capital ratio

Another way to assess the situation is by looking at your working capital ratio, also known as the current ratio. This tells you how many times your company can cover its debts with its assets.

This working capital calculation is straightforward, simply dividing assets by liabilities:

Current ratio = current assets / current liabilities

Returning to our working capital example, we divide current assets of £50,000 by current liabilities of £35,000 to find that the business has a current ratio of 1.4.

There’s some variation in what experts consider a healthy range. While many accountancy firms suggest a sweet spot between 1.2 and 2.0, others propose a broader golden range from 1.5 to 3.0.

The consensus, though, is that a ratio of less than one suggests liquidity problems. In other words, your business might be in for a bit of a squeeze when it comes to paying off what you owe.

Remember though that an excessively high working capital ratio can be as problematic as too little. It may mean that you’re holding onto too much cash or other assets, and perhaps missing out on chances to implement viable ideas for how to make extra money through your business.

The quick ratio

Another common working capital ratio known as the quick ratio or the acid-test ratio removes inventory from the equation. It looks like this:

Quick ratio = (current assets – inventory) / current liabilities

This is helpful for businesses where inventory doesn’t turn into cash overnight, such as a boutique furniture store specialising in custom-made pieces. By focusing on the most liquid assets, the quick ratio tells you whether you can cover your immediate debts, no matter what’s sitting on your shelves.

Components of working capital

As we touched on earlier, there are two main components that are commonly taken into account when considering working capital: your current assets and your current liabilities.

Current assets

Current assets encompass what you’ve got in the bank (such as money made from core business activities as well as from exploring how to make money on the side) and what you can quickly turn into cash within the next 12 months.

To break this down further, your current assets can include:

Cash on hand 

This is the cash you have available for immediate and short-term use in your business, a crucial factor whether you’re just exploring how to make money from home or further along your journey and pondering how to scale a business. It includes foreign currency and cash equivalents like stocks and bonds.

Inventory 

This refers to your stock levels, from items waiting to be sold and those midway through assembly, right through to raw materials set for production. Effective stock management significantly impacts your business’s ability to adapt and grow, making it an important aspect of how to run a business successfully.

Accounts receivable 

This part covers the money customers owe you for goods and services that have been delivered but not yet paid for. It’s essentially about ensuring you get paid for what you sell on credit, which is vital for keeping your cash flow forecast on track.

Notes receivable 

These are debts owed to your business through formal agreements and due within 12 months. Often arising from loans you’ve provided, these repayments can boost your cash reserves, helping to fund, say, low cost business ideas or simply adding a financial safety net.

Prepaid expenses 

This covers any payments you’ve made ahead of time, such as for rent or insurance policies that mitigate risks or may be part of the legal requirements for starting a small business in your sector.

While these payments can tie up funds and aren’t easily converted into cash, they count as assets because they confer benefits over a future period and bring predictability to your small business expenses.

Other quick assets 

These include things like tax rebates or other receivables not tied to your core operations. Such assets may come from ideas for second income streams such as creative ways to make money running in parallel to your main enterprise, and can help give your business a buffer to cover unexpected expenses.

Current liabilities

Current liabilities are the payments you need to tackle in the short-term, like bills or loan repayments becoming due in the next 12 months. One of the main goals of calculating working capital is to understand whether you’ll have enough money to cover these expenses with the resources you currently have.

Your business’s current liabilities can include:

Accounts payable 

This covers unpaid bills for things like raw materials, utilities and rent. If you’re exploring how to start an online business or expect to utilise the internet in a major way, it might include costs for initial SEO or digital marketing services. Typically, invoices are due in 30 days, meaning practically all outstanding invoices show up here.

Wages payable 

These are the wages you owe to your team but haven’t paid out yet, potentially spanning up to a month depending on payroll frequency. Mastering how to do a payroll helps ensure your business can meet its salary obligations on time, maintaining a healthy cash flow, avoiding disruptions and aiding in employee retention.

Accrued taxes 

Including the likes of VAT and corporation tax, as well as PAYE and National Insurance contributions, this section covers taxes your business owes but hasn’t paid yet. Staying ahead of these payments helps your financial planning stay on point and your business to avoid penalties.

Dividends payable 

If you’ve already committed to paying dividends to shareholders, this is the amount you’re expected to distribute. Regular dividend payments signify stability and profitability, and tend to be viewed favourably by investors considering how to value a business.

This year’s debt payments  

These are the portions of longer loans you need to settle within the current year. Let’s say you took out a five-year loan to kickstart one of your small business ideas. Only repayments due over the next 12 months count; the rest is considered a long-term liability.

Customer prepayments 

This refers to money you’ve received for services or products you haven’t delivered yet, such as through the sale of online gift cards. While these payments boost cash flow upfront, they also represent commitments to future delivery that your business will need to meet.

Where to find the figures

There’s no tricky financial analysis involved in finding the numbers for your working capital calculation – your business’s current assets and current liabilities should be readily available on your balance sheet.

If you’re at the early stages of your business and don’t yet have a balance sheet, other documents can provide the necessary estimates. 

These include your cash flow statement, bank statements, and any outstanding invoices. Paperwork outlining your initial small business budget can also help you pull together the numbers you need.

How much working capital do you need?

Wondering how much working capital you need to keep your business humming along and ready for growth? The right amount of working capital hangs on several factors, such as what your business does, how it does it, and where you see it heading.

While there’s no magic number that fits every business, considering your working capital cycle and your growth plans offers a good starting point.

Working capital cycle

Your working capital cycle measures the time it takes your business to turn what it sells into cash in the bank.

If you’ve got a retail store or work in the food and drink industry, you might zip through this cycle fast and need less cash on hand. But if you deal with things to make and sell, for example as a manufacturing company, you’re usually in for a longer wait – meaning you’ll need a bit more cash to cover the gap.

Growth plans

Got your sights set on expansion plans, such as diversifying your product lines or investing in professional point-of-sale solutions like POS Pro? You might need a financial cushion.

This is because growth typically requires investment in inventory and resources before bringing in additional cash, making your working capital cycle longer. Making sure you have enough working capital is key to backing up your plans without messing up your cash flow.

How to improve working capital

A healthy working capital means your business will have the agility to respond to opportunities and challenges alike. Here are some rules of thumb to keep in mind for boosting your working capital.

1. Save cash

Building a larger cash reserve is key for staying flexible, whether in terms of overcoming short-term expenses for your main business, or exploring new projects. If, say, you’re thinking about how to start a side hustle alongside your main enterprise, having cash ready lets you quickly jump on new opportunities.

2. Prepay expenses

Where possible, take advantage of discounts for prepaying expenses like rent or insurance. Although this strategy ties up cash in the short term, it can lead to savings and more predictable cash outflows, potentially improving your net cash flow.

3. Consider credit offers carefully

Extending credit can be a real driver when it comes to getting clients, but also increases the risk of bad debt. Reduce the risk by conducting thorough credit checks and establishing clear credit policies before offering credit.

4. Shorten your receivables period

Speeding up how fast you get paid from accounts receivable can help your cash keep flowing in a timely manner, cutting down the need to borrow money. You might try making your invoicing and collection processes slicker, or consider offering discounts for early payments to get customers paying quicker.

5. Leverage technology

Modern tech solutions like contactless payments via QR codes and mobile devices can streamline the cash collection process, shaving days off your working capital cycle. You can also take advantage of subscription plans like SumUp One, which guarantees all payments will be with you by 7am the next day, even on weekends and public holidays.

Challenges with working capital

Understanding working capital is useful for any small business entrepreneur, but it’s important to be aware of its limitations.

Sp, before we wrap up, let’s explore some of the most common pitfalls relating to working capital, and how you can deal with them.

Fluctuating figures

Working capital isn’t a static sum. As you run your business day-to-day, your assets and what you owe are likely to shift. 

To handle the ups and downs of working capital, make time to regularly keep a close eye on your finances, and where possible, opt for accounting tools for small businesses that offer real-time updates. This way, you’re always making decisions with the most current figures.

Relying on payments owed

When you count too much on the money that's supposed to come in, it might look like you've got plenty of working capital, but your cash flow may be negatively impacted.

Effective customer retention and customer acquisition efforts can be key to diversifying your revenue streams and reducing your reliance on a few large receivables. For example, you could start a customer loyalty program or learn how to use social media for small business to pull in a wider crowd.

Asset depreciation

Holding more stock can increase the value of current assets, but it’s certainly possible to have too much of a good thing. Items can become outdated or even get stolen, which means your working capital might not be as strong as you think.

To dodge the inventory depreciation issue, keep a tight grip on your stock levels. Use strategies like just-in-time inventory to hold only what's necessary. This keeps your cash flow healthier and your working capital more reliable.

Overlooked debts

Managing debts is crucial for startups and established businesses alike. It's easy to miss some, especially in the hustle and bustle of daily operations. If you’re not vigilant, these forgotten debts can suddenly undermine what seemed like a solid working capital.

To prevent this, regularly review your financial commitments. Small business risk management strategies, like implementing a robust tracking system for all financial transactions and setting reminders for due payments, can provide clear visibility on all your debts and help you stay on top of things.

Limited cash flow

Sometimes, working capital looks good on paper but doesn’t tell you if you can access cash when you really need it. Let’s imagine you’ve explored how to start a business from home and have decided upon selling rare and collectible books online. These items, while valuable, might not sell quickly.

This slow turnover means that even though your assets look healthy in your accounts, they won't help much in a financial pinch. To improve your situation, you could diversify your marketing strategy for small business or run regular promotions and sales to help speed up inventory turnover.

Additionally, exploring additional sales channels or attending small business networking events can widen your market reach, leading to improved liquidity and ensuring you have cash available when needed.

Disclaimer: The contents of this page are intended for informational purposes only and should not be construed as professional advice. For matters requiring legal or financial expertise, it’s recommended to seek guidance from qualified professionals.