Many medium-sized businesses grow quickly but still run out of cash.

Profitability doesn't always mean a business will have access to funds when needed. Understanding and managing working capital properly can help a business scale while still having the cash to cover current expenses.

For CFOs and finance teams juggling multiple locations and an expanding workforce, cash flow and the effects of working capital are a daily operational concern. When you manage working capital properly, you free up cash, reduce financial risk, and support long-term growth.

In this guide, you'll learn what working capital is, why it matters for mid-market businesses, and how you can track it to make smart business decisions. 

Table of Contents

• Working capital: Definition
• How to calculate working capital
• Working capital vs. net working capital
• Why working capital matters
• What is a good working capital ratio?
• Common red flags in working capital management
• How to improve working capital
• Strategic uses of surplus working capital
• Managing working capital across multiple entities or locations
• Working capital in financial forecasting and reporting
• How to monitor working capital
• FAQ

Working capital: Definition

Working capital is a financial ratio used to determine liquidity — a company's ability to cover its current expenses and short-term obligations in order to keep the business running smoothly. It is calculated by subtracting current liabilities from current assets.

When businesses grow, the demands on their cash flow and the ability to pay their bills increases too. In this case, working capital becomes a key performance indicator that can be used to make important decisions.

How to calculate working capital

Working capital is calculated by subtracting current liabilities (per the balance sheet) from current assets.

Working capital formula

Working capital = Current assets - Current liabilities

Current assets include:

• Cash
• Accounts receivable
• Inventory
• Prepaid expenses
• Short-term investments

Current liabilities include:

• Accounts payable
• Sales and income taxes
• Wages and interest payable
• Short-term loans and the current portion of any long-term debt
• Unearned revenue

Example of working capital calculation

1. A Toronto-based manufacturing firm has the following current assets and current liabilities:

• Inventory = $300,000
• Accounts receivable = $400,000
• Cash = $100,000
• Accounts payable = $500,000
• Accrued expenses (taxes and salaries payable) = $100,000

2. To calculate working capital, first determine total current assets and total current liabilities.

Total current assets = $300,000 + $400,000 + $100,000 = $800,000

Total current liabilities = $500,000 + $100,000 = $600,000

3. Then determine working capital as follows:

Working capital = $800,000 - $600,000 = $200,000

This manufacturing firm has $200,000 available to fund daily operational activities. 

Working capital vs. net working capital

A working capital analysis can be taken a step further by understanding net working capital and what it signals. Net working capital excludes very liquid items like cash and non-operational items such as short-term debt. This gives the finance department an idea of how much capital is tied up in the core operations of the business.

The formula for net working capital is:

Net working capital = (Current assets - Cash) - (Current liabilities - Short-term debt)

For example, a retail business has $1,000,000 in current assets, of which $250,000 is cash. Current liabilities are $800,000, including $200,000 in short-term debt.

Net working capital = ($1,000,000 - $250,000) - ($800,000 - $200,000) = $150,000

For this same business, working capital would be:

Working capital = $1,000,000 - $800,000 = $200,000

The net working capital calculation tells us that of the $200,000 working capital, $150,000 is used for the core operational activities of the business. 

Why working capital matters

When working capital is strong, it smooths daily operations by covering wages, rent, and supplier payments. Excess current assets, especially a strong cash balance, means that businesses can take advantage of bulk buying or early payment discounts when available.

A good working capital number can also provide a buffer when payments are slow to come in from customers or there's a delay in the supply chain. As companies grow, they need tighter cash control to prevent disruptions across locations or departments.

Scaling businesses

When businesses grow, there are more moving parts to consider — like increased employees resulting in more payroll expenses. More sales mean more invoices to send out and more inventory to manage. With increased customer accounts to manage, there's a higher chance that customers are also taking longer to pay their bills.

This all results in higher stress on cash flow. Tracking working capital can help finance teams forecast needs and reduce financing costs and the reliance on emergency loans. A business increasing its workforce from 25 to 100 employees will see larger cash outflows before sales have a chance to catch up.

What is a good working capital ratio?

In order to know if a working capital ratio is good, first you need to know how to calculate it.

Working capital ratio = Current assets / Current liabilities

If we calculate the working capital ratio using the same figures from the last example for the retail business, we get:

Working capital ratio = $1,000,000 / $800,000 = 1.25

This tells us that this fictional retail business has 1.25 times more current assets than liabilities. But is this good? It's hard to say without knowing the business's industry. Statistics Canada keeps profiles on various businesses by industry. It's not always the most up-to-date, but it can be helpful to see how your business compares to the industry as a whole.

When we adjusted the parameters at the Statistics Canada site to show a profile for a retail trade business in a functional urban area, it showed a current ratio of 2.0 for 2022 (the most current data available). This means the fictional retail business has a working capital ratio that's below the industry standard.

A ratio below 1.0 is a red flag regardless of parameters, because that tells you the business is not meeting their short-term financial obligations with their current assets. And when the ratio exceeds 2.0 — while that seems like it could be a good thing — it could mean there's an inefficiency, such as cash tied up in inventory. 

Common red flags in working capital management

For scaling businesses, low working capital could be an early warning sign of issues that might escalate quickly if left unchecked. This includes operational inefficiencies, slow payment collection, and cash flow stress.

If working capital is low, some common places to check for issues include:

• Receivables collection: The longer customers take to pay, the longer it takes for sales to be converted into cash.
• Accounts payable: If supplier payments are delayed as a result of cash shortages, this will increase the value of current liabilities and decrease working capital.
• Inventory bloat: When companies overstock items, cash becomes stuck in inventory that isn't sold right away and storage costs increase.
• Overextended or excessive credit: Even if revenues are stable, taking on new loans to pay bills indicates the business has some liquidity issues.

All these issues eventually lead back to cash flow stress. For a growing business, this can trigger issues paying employees and suppliers and even lead to missed growth opportunities.  

How to improve working capital

Working capital can be improved by keeping an eye on the accounts that factor into the working capital calculation — those classified as current assets and current liabilities on the balance sheet.

To mitigate common red flags, try the following:

• Accelerate receivables: Offer incentives like early payment discounts and try automated reminders as follow-up to the initial invoice.
• Manage payables: Ideally, you'll want to pay suppliers as soon as you can. Set reminders so payments don't get missed. If the company is strapped for cash, try renegotiating supplier terms and paying on the last day of the term to conserve cash.
• Optimize inventory: Use forecasting models to predict the amount of inventory needed, or adopt a just-in-time inventory management system.
• Assess credit levels: Try not to use overdrafts or debt for daily operations unless absolutely necessary.

Automating collection procedures and inventory tracking can go a long way toward helping finance teams avoid errors during the manual reconciliation process as data scales in a growing business. 

Strategic uses of surplus working capital

On the flip side, when a company's working capital ratio is healthy, there are lots of strategic ways this can be used to the benefit of the business.

Strong working capital and a robust cash flow go hand in hand, providing CFOs and finance teams with the opportunity to make some impactful decisions.

This is a great time to consider the company's goals. Excess cash provides a chance to reinvest in the business through capital assets like equipment. If the company has any high-interest debt, cash could be used to pay it down and reduce long-term costs. For seasonal businesses, management may want to consider building cash reserves for slower times.

Other ways to invest in a business include:

• Hiring more staff
• Expanding in the current market
• Testing a new market
• Exploring research and development projects for future products or processes

Strategically investing in the company whenever possible results in a business that has a higher overall value and stronger investor confidence. 

Managing working capital across multiple entities or locations

Managing working capital across locations or entities can be tricky if each location has its own payment cycles, suppliers, and inventory needs. One way to make this easier is to centralize cash flow reporting (so all payments are made through the head office, for example) or standardize procedures (causing payment cycles to line up).

For example, a restaurant chain with locations in five cities across Canada may experience different cash flow patterns due to regional pricing or variations in supplier delivery schedules.

To help manage working capital more consistently, the chain could use a unified system to track stock levels across all locations and set standard reorder points and lead times. They could also standardize pricing instead of letting each location set its own.

Working capital in financial forecasting and reporting

Accurate forecasting supports better decision-making and risk management, especially during expansions or high-demand seasons. When working capital is considered as part of the cash flow forecasting process, managers gain deeper insight into when cash comes and goes. The key metrics to track in this regard are days sales outstanding and days payable outstanding.

Days sales outstanding = (Accounts receivable / Total credit sales) x Number of days in the accounting period

Days payable outstanding = (Average accounts payable / Cost of goods sold) x Number of days in the accounting period

To calculate average accounts payable, look at the accounting period you're examining.

Take your starting accounts payable and your ending accounts payable and divide by two to get the average accounts payable for the period. The fewer days sales are outstanding the quicker cash is coming in, and the fewer days payables are outstanding the quicker cash is going out.

How to monitor working capital

Accounting tools like QuickBooks Online Advanced have the functionality to make managing working capital more efficient, accurate, and proactive.

From custom dashboards for cash flow and current liabilities to automated alerts for overdue invoices, each interface is designed to reduce manual work and provide real-time visibility. QuickBooks Online Advanced has the right-sized tools for scaling businesses.