Working capital: Definition, formula, & management tips

Successful managers make informed business decisions based on metrics, one of which is working capital. No business can operate without generating sufficient cash inflows, and monitoring working capital can help you get enough cash in the door each month.

You can use the components of working capital and some key financial ratios to improve your outcomes and your business’s short-term financial health. Read more to explore what working capital is, its formula, and helpful management tips.

What is working capital?

Working capital is an accounting formula that is calculated by subtracting a business’s current liabilities from its current assets. These assets can include cash, customers’ unpaid bills and inventory. Liabilities are any current loans, amounts owed and accounts payable.

Generally, a business with a positive WC has more potential to grow and invest than a business that has current liabilities that are more than its current assets. If this is the case, a business may have trouble paying back what is owed to its creditors and may go bankrupt as a result.

Why is working capital important?

Working capital is important because it measures how efficiently a business operates, its financial health and its liquidity or cash flow - the ability to generate sufficient current assets to pay current liabilities. 

If you don’t generate enough current assets, you may need to borrow money to fund your business operations. If your business’ current assets don’t exceed its short-term liabilities, it won’t survive for long. Good working capital management will keep your business operational and can help you avoid cash flow problems.

Reasons your business may require additional working capital

On top of the many reasons why working capital is important, there are times when your business may need additional capital to stay adaptable with the industry and other business needs. Here are some reasons why that may be the case: 

• Seasonal differences: Cash flow changes happen seasonally for many businesses, so additional capital may be required to help prep for a busy season or keep things operating when there’s less cash available. 
• Supplier discounts: If you need to boost your capital, purchasing in bulk can allow you to take discounts that many suppliers offer.
• Covering expenses: Additional working capital may be needed to pay temporary employees or to cover miscellaneous project-related expenses. 
• Obligation funding: Sometimes your business will need working capital to help fund obligations to employees, suppliers, and the government while waiting for customer payments.
• Supplier Payments: If goods are imported or terms to suppliers are short additional capital may be needed to pay suppliers until goods are sold and customers have paid.
• Business expansion: There may be circumstances where you need working capital to fund unpredicted business expansion projects which may have long term benefits to the business despite the short term cost. 

The working capital formula is calculated by using the current ratio. A ratio higher than one means that current assets exceed liabilities, thus resulting in a better score:

Working capital = current assets – current liabilities

Assets and liabilities are included in a balance sheet, and you’ll use the components of the balance sheet to calculate the working capital. A balance sheet is a financial statement that reports assets, liabilities, and equity balances as of a specific date. 

Here are the components that make up a balance sheet:

• Assets are what your business owns. Assets are resources used to produce revenue. If you’re a plumber, your truck and the equipment you use are defined as assets.
• Liabilities are what your business owes to other parties. Liabilities include accounts payable and long-term debt.
• Equity is the difference between assets and liabilities, and you can think of it as the true value of your business. If you sold all of your assets for cash and used the cash to pay all your liabilities, any remaining cash is equity.

For example, if a retail company has current assets that are worth $70,000 and current liabilities worth $30,000, then its working capital would be $40,000. 

Current assets include cash and assets that will be converted into cash within 12 months. On the other hand, current liabilities are bills that must be paid within 12 months, including accounts payable, short-term debt, and the current portion of long-term debt. GST and superannuation payable are also current liabilities.

Operating working capital definition and formula

Operating working capital includes the current assets and current liabilities that relate to day-to-day operations of a business, rather than WC, which looks at total assets and liabilities. 

Operating working capital = (cash + accounts receivable + inventory) − (accounts payable + accrued expenses)

Operating working capital only includes the most important components in the formula. Prepaid expenses and loans owed to you are two current asset accounts that are excluded from the calculation because they don’t relate to daily business operations and are used less frequently.

Also Read: 8 accounting formulas every business should know

Current asset accounts

To recap, current assets include cash and assets that will be converted into cash within 12 months and current liabilities are bills that must be paid within 12 months. 

Common current asset accounts

Most businesses use these current asset accounts to operate:

• Cash and cash equivalents: The total amount of money on hand or in bank accounts
• Accounts receivable (Debtors): The amount that your customers owe you after buying your goods or services.
• Inventory: Items purchased for resale to customers.
• Investments: Money market account balances, stocks and bonds. Some investments may be categorised as long term, but most are short-term assets.
• Receivables: Amounts you are owed that will be paid within 12 months.

Common current liability accounts

Current liabilities are amounts owed to third parties that must be paid within 12 months. The most common liabilities include:

• Accounts payable: Utility expenses, subscriptions, and amounts owed to other vendors, such as monthly bills.
• Payroll liabilities: The dollar amount of payroll owed on the next pay date is a current liability.
• Debt payments: Amounts due on short-term business loans, such as a line of credit or credit cards, or any long-term debt where repayments to a lender must be made within a year.

What is the working capital cycle?

The working capital cycle measures the number of days required to convert net working capital into cash. Here’s an example that demonstrates the working capital cycle for both a manufacturer and a retailer: 

Manufacturer 

The manufacturer - a furniture builder in this case - purchases raw materials, builds furniture, sells finished goods to customers and collects payment in cash. The working capital cycle requires 45 days.

Retailer

The retailer buys inventory, sells goods to customers and collects payment in cash. The working capital cycle is completed in 30 days.

The number of days in the cycle depends on the industry and the complexity of the business. For example, an aeroplane manufacturer will have a longer cycle than a greeting card retailer because building a plane can take a year or longer.

Both online sales and items sold in a physical store must be converted into cash after the sale. A business with a shorter working capital cycle can operate using less cash than other businesses. If you can collect money faster, you can purchase inventory sooner and fund other needs.

How to use working capital ratios

There are four key ratios you can use to monitor your working capital balance.

1. Current working capital ratio

The current ratio uses the same formula as the working capital formula. The ratio is current assets subtracted by current liabilities, and every business needs to maintain a ratio of at least 1.0.

Working capital = current assets – current liabilities

For example, a business with $120,000 in current assets and current liabilities totalling $100,000 has a current ratio of 1.2. 

The owner has $1.20 in current assets for every $1 of current liabilities.

2. Quick working capital ratio

The quick ratio (or acid test ratio) adjusts the current ratio formula by subtracting some current assets that take longer to convert into cash. 

There are several versions of the formula, but the most common subtracts inventory and prepaid expenses from current assets. The remaining balance is divided by current liabilities: 

Quick ratio = (current assets – inventories – prepaid expenses) ÷ current liabilities

Using the same example as above, assume that the business has $10,000 in inventory and no prepaid asset balance. The adjusted current asset total is $120,000 minus $10,000, equalling $110,000. The quick ratio is $110,000 divided by $100,000, coming out to 1.1.

3. Accounts receivable turnover ratio

The accounts receivable turnover ratio is net annual credit sales divided by average accounts receivable. 

Accounts receivable turnover Ratio = net annual credit sales ÷ average accounts receivables 

The components of the formula are as follows:

• Credit sales: Sales to customers who don’t pay immediately.
• Net credit sales: Credit sales minus uncollectible accounts receivable balances.
• Average accounts receivable: The beginning balance plus ending balance for a month divided by two.

A business should strive to increase credit sales while also minimising accounts receivable. If you can increase the ratio, that means you’re converting accounts receivable balances into cash faster.

4. Inventory turnover ratio

The inventory turnover ratio is computed as the cost of goods sold divided by average inventory:

Inventory turnover ratio = cost of goods sold ÷ average inventory

If you can increase sales and minimise inventory levels, the ratio will increase. Increasing the ratio means that you are making more sales without having to increase the inventory balance at the same rate.

Put each of these ratios on a financial dashboard so that the information is right in front of you each month. These ratios are the best tools for assessing your progress and increasing working capital.

Seven working capital management tips

Working capital management is an accounting strategy that helps businesses maintain a healthy balance between current assets and liabilities. 

There are a few working capital management tactics that you can use to improve your working capital, increase efficiencies and ultimately improve earnings. Here are a few tips to manage working capital:

1. Create a cash flow roll forward

Find out where you stand in terms of your financial status. Forecast your cash inflows from sales and your required cash outflows by month. Each month’s beginning cash balance plus cash inflows, minus cash outflows equals your ending cash balance. 

If your plan for the next six months reveals negative cash balances, you’ll need to collect cash faster. Once you know the extent of the problem, you can take action.

2. Monitor accounts receivable

Generate an accounts receivable ageing schedule each month. The report lists the dollar amounts you’re owed based on the date of the invoice. 

Ageing reports typically group invoices based on 0 to 30 days old, 31 to 60 days old and so on. Older invoices present a higher risk of not being paid.

3. Enforce a collections policy

You should have a written policy for collecting money, and the policy must be enforced to increase cash inflows. Decide on payment terms that encourage early payments. 

For example, you might email a client once an invoice is 30 days old and call on invoices once they reach 60 days old. If a customer pays late on every sale, consider whether you should do business with the client moving forward. Consistent late payments impact your cash inflows.

4. Manage inventory purchases 

If inventory is a large component of your cash outflows, monitor your purchases closely. Buy enough inventory to fill customer orders but not so much that you deplete your bank account - less inventory leads to more cash flow that’s freed up. 

Implementing effective inventory management can have a positive impact on accounts payable, receivable, operations and the overall growth of a business. 

5. Offer discounts

Offer customers a discount (1% to 2%) if they pay within five days of receiving the invoice. You’ll collect money faster, which may be more valuable than the 1% to 2% you lose when the customer takes the discount.

6. Accept multiple payment methods

Make it easy for customers to pay you by offering electronic payment methods on your website. Accept credit and debit cards, and email customers an invoice with a link to make payments.

7. Pay vendors on time

Small business owners can maintain good relationships with vendors by paying them on time. If you’re able to speed up your cash inflows, you can make timely payments and maintain a sufficient cash balance.

If you implement these changes, you’ll convert current assets into cash much faster. Increasing working capital requires a focus on current assets, which are easier to change than current liabilities.

Take action and improve your results

It’s easy to feel overwhelmed by the amount of financial information you can access about your business. However, focusing on the most important metrics like working capital can help you stay organised. By analysing the ratios and following the various tips mentioned above, you’ll be better able to make changes to your business structure to help improve growth and drive results.

Be sure to take advantage of QuickBooks Online Accounting Software to help with your books and track your finances.