A small wholesaler lands its biggest order yet. The goods have to be bought now, the customer pays in sixty days, and the warehouse rent is due on the first of the month as always. On paper the year looks excellent. In the bank account it looks tight. The gap between those two pictures is what working capital measures, and the calculation behind it takes only a few minutes.
The formula
Working capital is the difference between a business's current assets and its current liabilities:
Working capital = current assets − current liabilities
"Current" means items expected to turn into cash, or fall due, within roughly the next twelve months. Both figures come from the balance sheet, which your accounting software or accountant can produce for any date.
| Current assets | Current liabilities |
|---|---|
| Cash in bank and on hand | Supplier bills (accounts payable) |
| Money owed by customers (accounts receivable) | Wages and other costs owed but not yet paid |
| Stock, raw materials and work in progress | Tax and VAT or sales tax due |
| Prepaid expenses, such as rent paid in advance | Overdraft and the part of any loan repayable within a year |
| Short-term deposits that can be released quickly | Customer deposits for work not yet delivered |
Working it out step by step
- Choose a date, ideally a month-end, and pull the balance sheet for it.
- Add up every current asset. Be honest about stock: slow-moving or damaged items are worth less than their cost.
- Add up every current liability, including the share of longer loans due within twelve months.
- Subtract the second total from the first.
- Repeat at the same point each month so you see the trend, not just a snapshot.
A made-up example shows the shape of it. Suppose a firm holds 8,000 in cash, is owed 22,000 by customers and has 15,000 of stock, giving 45,000 in current assets. It owes suppliers 18,000, has 6,000 of tax to pay and 4,000 of loan repayments due this year, giving 28,000 in current liabilities. Its working capital is 17,000. The figures are invented; the method is the point.
Reading the result
Positive working capital
A positive figure means the business expects to have more coming in from short-term assets than it has to pay out over the same period. That is generally reassuring, but bigger is not automatically better. A large surplus can mean cash is sitting idle, or that stock and unpaid invoices are piling up when they should be turning over.
Negative working capital
A negative figure means current liabilities exceed current assets. For many small firms that is a warning: bills could fall due before the money to pay them arrives. Context matters, though. Some businesses, such as certain retailers and food outlets, are paid by customers immediately while paying suppliers on credit, so they can run with negative working capital for long periods without distress. The question is whether the pattern is built into the model or a sign of strain.
The current ratio
Dividing current assets by current liabilities gives the current ratio. In the example above, 45,000 divided by 28,000 is about 1.6. A ratio below 1 matches negative working capital. There is no single correct ratio for every sector, so comparing your own figure over time is usually more useful than chasing a textbook target. Lenders often look at it, and some build minimum ratios into loan agreements.
The working capital cycle
The single figure is a still photograph. The working capital cycle is the film: how many days pass between paying for stock or materials and collecting cash from the customer who eventually buys them. It is usually broken into three parts.
- Stock days: how long goods sit before they are sold.
- Debtor days: how long customers take to pay after being invoiced.
- Creditor days: how long you take to pay your own suppliers.
Stock days plus debtor days, minus creditor days, gives the length of the cycle. The longer it is, the more cash the business needs to keep running, and the more growth can hurt: every extra order stretches the gap. Producers that sell through wholesalers often feel this sharply, which is one reason the payment terms agreed with partners matter so much, as our article on working with food distributors in the UK points out.
Ways to improve the position
- Invoice on delivery and follow up promptly, so debtor days fall.
- Agree deposits or stage payments on large jobs.
- Order stock closer to when it sells and clear slow lines.
- Negotiate supplier terms that match how long your own customers take to pay, while keeping a good payment record.
- Keep the short-term portion of debt in view when planning, since it counts against working capital.
- Use a budget to plan the lumpy outgoings; our guide to building a small business budget covers the practical side.
Where the cycle is long by nature, finance linked to receivables can shorten it. We look at the effect on day-to-day running in our article on factoring and operational cash flow. Quick-access products such as merchant cash advances also exist, but their cost can deepen the problem they are meant to solve.
Working capital and cash flow
The two ideas overlap but are not identical. Working capital describes the position at a given date; cash flow describes movement over a period. A firm can show healthy working capital and still run short of cash in a particular week if a big customer pays late. That is why the monthly calculation works best alongside a rolling forecast, explained in cash flow management basics for small firms.
Common mistakes
- Counting stock at full value when part of it will never sell.
- Forgetting the slice of a long-term loan that falls due this year.
- Treating overdue customer balances as certain cash.
- Looking at one month in isolation, including a seasonal peak or trough.
Working capital is a simple number with a lot of judgment hiding inside it. If the trend is falling, or the figure has turned negative without an obvious reason, an accountant can help work out whether the cause is pricing, payment terms, stock control or the structure of the business's borrowing. This guide is general information rather than advice for a specific firm.
