What working capital is, and how to calculate it

Working capital is the money a business has available to run day to day — to pay staff, suppliers and bills while it waits for its customers to pay it. It is the difference between what you have coming in over the next year and what you have going out.

The formula

Working capital = current assets − current liabilities

• Current assets are what can turn into cash within a year: money in the bank, what customers owe you (receivables), and stock you will sell.
• Current liabilities are what you must pay within a year: supplier bills (payables), wages owed, taxes due, and the next twelve months of loan payments.

A worked example:

• Cash: $40,000
• Receivables: $85,000
• Inventory: $60,000
• Current assets: $185,000
• Payables: $55,000
• Wages and taxes owing: $20,000
• Loan payments due this year: $35,000
• Current liabilities: $110,000

Working capital: $185,000 − $110,000 = $75,000

The working capital ratio

Dividing instead of subtracting gives the current ratio:

Current ratio = current assets ÷ current liabilities

In the example, $185,000 ÷ $110,000 is about 1.7. Above 1 means you have more coming in over the year than going out. Below 1 means you are relying on money you do not have yet.

What counts as healthy varies by industry. A grocer turning stock every few days runs very differently from a builder waiting sixty days on a progress payment.

Why profitable businesses still run short

Working capital is about timing, not profit. A business can be profitable on paper and still be unable to make payroll this Friday, because:

• Customers pay late. You did the work in March; the money arrives in May.
• Stock ties up cash. Money spent on inventory is not available until the stock sells.
• Growth eats cash. More sales means more stock and more receivables before more cash — the faster you grow, the tighter it can get.
• Seasons. Costs arrive before the busy season's revenue does.

How to improve it

• Get paid faster. Invoice promptly, shorten payment terms where you can, and follow up the day an invoice is late.
• Pay on time, not early. Use the terms your suppliers give you.
• Carry less stock. Slow-moving inventory is cash sitting on a shelf.
• Watch the payments you have taken on. Loan and advance payments come straight out of working capital every month.

If payday is the pressure point, when payroll is due and the cash is not there covers what to do this week.

When to borrow for it

Borrowing to cover working capital makes sense when the gap is timing and the money is coming:

• A line of credit for gaps that come and go — you draw what you need and pay for what you draw.
• Asset-based lending or invoice factoring when the cash is tied up in receivables or stock.
• A term loan or a short-term loan for a one-off — a big order, a season's stock.

It does not make sense when the gap is that costs are higher than revenue. Borrowing covers that for a while, and then it adds a payment to the problem.

What it costs to borrow for it

What working capital costs shows how to read a working capital offer by the total you repay, and the business loan calculator will estimate both how much you could borrow and what it would cost.