A guide to working capital for small businesses

What is working capital?

Working capital is the cash and credit available to a business to meet its day to day payments and obligations, such as wages, bills and stock payments to suppliers. It fluctuates on a daily, even hourly basis as payments are made and monies received into the company’s bank accounts. For this reason, we often talk about a working capital cycle, as it rotates throughout the month.

How to calculate working capital

Calculating your business's working capital is simpler than it might seem. Here's how you can do it step-by-step:

1. Calculate your current assets

Add up the value of everything your business owns that can be easily converted to cash within a year. This could include cash in your bank, the value of your stock or the money owed to you by customers (receivables). 

2. Calculate your current liabilities

Add up the value of everything your business needs to pay within a year. This includes any work in progress, bills and expenses, wages, taxes, money owed to suppliers (payables) and any other short term borrowings. 

3. Apply the working capital formula 
The working capital formula is simply: 

Working capital = current assets − current liabilities

So, all you need to do is subtract the sum of your liabilities from the sum of your assets: The difference is your working capital.

Using this formula helps you understand if you have enough working capital to meet your business demands or if you need additional resources, such as a working capital loan. 

What does the sum of your working capital calculation mean? 

After using the calculation, you’ll arrive at a figure for your working capital. This could either be a positive or negative figure. Here’s a breakdown of what these mean: 

Positive working capital

If the sum of your working capital formula is positive, it means your business has more current assets than current liabilities. This indicates that your business is in a good position to cover its short term obligations and you could have enough working capital to reinvest back into your business’ growth. Positive working capital means you have a buffer to handle unexpected expenses, take advantage of new opportunities, and generally ensure the smooth operation of your business.

Negative working capital

If the sum of your working capital formula is negative, it means your business has more current liabilities than current assets. This can indicate potential financial trouble, as your business may struggle to meet its short term obligations. Negative working capital can be a sign of liquidity issues, and if not addressed promptly, it could lead to difficulties in maintaining operations, paying suppliers, and meeting payroll.

Why is working capital important?

Working capital is essential for keeping your business running smoothly. It makes sure you can pay your bills, employees, and suppliers on time, and allows you to invest in new opportunities for growth. Without enough working capital, your business might struggle to cover its expenses, causing disruptions in your operations. 

If you don't have enough working capital to fulfil an order or project, it could lead to delays, poor supplier relationships, or even the project's failure, which can damage your business's reputation and financial health. For these reasons, having enough working capital is so important for your business's success and growth.

Working capital ratio

Another useful measure is the working capital ratio, also known as the current ratio. It can be a good way to measure a company's ability to cover its short term liabilities with its short term assets. This provides a clear snapshot of a business’s financial health and operational efficiency.

To work out your working capital ratio, divide your total current assets by the total current liabilities.

What is a good working capital ratio?

• Ratio of less than 1.0
  This means the business has more current liabilities than current assets and may struggle to make all payments on time.

• Ratio between 1.0 - 2.0

  Indicates a positive position where the business can meet normal short term requirements and cover unexpected costs.

• Ratio of 2.0 and above

  This suggests the business may be hoarding cash instead of investing it for growth, which can be detrimental in the long term.

What are the benefits of a good working capital ratio?

A business needs to have access to working capital to be able to trade.  Suppliers will expect to be paid for stock bought, or employees paid wages for their hours worked.  

When a business is growing, they spend more in order to then sell more products or services. That time difference is funded by working capital.  

The more working capital a business has, the faster they can grow.  

For example, with access to more capital, the company could pay for an advertising campaign or buy more stock, rent larger premises and recruit more staff. Without these in place, businesses cannot grow. 

If a company is relying only on its cash balances, it will only be able to grow slowly as it will need to wait for customers to pay them, before they can buy more stock.  And businesses which are able to offer their customers credit terms and fund that time delay, may find that those customers choose to trade with them more.

A very small business may be able to fund their stock and asset purchases using their cash plus the owners’ personal credit card facilities, but as the business grows, more forms of finance are available to provide a stronger base for future growth.

Why would I need to measure working capital?

Having access to a strong source of working capital will provide business owners with comfort as it can be called upon to cover one-off unexpected costs and can also help businesses to smooth out seasonal trends in income and costs.

Management teams need to know what working capital resources are available to the business when they are creating a business plan and considering the likely success of different growth strategies.

How does working capital affect cash flow?

Cash is a critical part of the working capital calculation. If other forms of working capital are not available, money will need to be drawn from the business’ bank account. This means tha the amount of cash flow will reduce, impacting the company's ability to cover daily expenses and invest in growth.

Strategies to improve your working capital

• Improve credit control
  Ensure strong credit control and debt recovery systems are in place so that customers pay quickly, bringing cash back into the business. You can easily improve your credit control process and check company credit scores with a Capitalise account. This will enable you to keep track of the companies you work with and spot any early warning signs of late payment.

• Payment terms

  Manage payments to suppliers carefully, staying within agreed terms but not paying earlier than necessary. This should be balanced against trade discounts.

• Manage monthly payments

  Try to control costs by negotiating the best prices, you could do this perhaps through competitive bidding. If you have a good business credit score and large credit limit, you’ll be in a strong position to negotiate with suppliers. Make sure to regularly check your credit score and see if there are areas you can improve it.

• Good business credit score

  Maintain a strong credit score with timely and complete management information to keep borrowing rates low. This will help to lower your monthly outgoings.

How can long term finance help working capital?

While maximising internal working capital resources is important, sometimes it's not enough. External finance, such as a business loan can provide extra cash flow to meet your business needs.  

You could consider a long term loan, where repayments are spread out over a longer period. This way, your monthly payments remain low and won't significantly impact your working capital, while giving you the cash injection you need. To qualify for a long term business loan, you'll need a strong financial history and a good business credit score. To check if you’re eligible for a long term loan, you can use your Capitalise for Business account. We work with 100+ UK lenders so that you can apply and compare your options and find the solution best suited to your business needs. To get started, just search for funding with Capitalise.