In small business, working capital describes the funds used to run the day to day business operations. ‘Capital’ is another word for money, so working capital is essentially the money the business uses for day to day operations.

Sufficient company working capital is required to meet the minimum operational costs of business. More importantly, additional working capital is required when a company is growing. It also allows them to take advantage of new opportunities or short-term investments.

Working capital is the heartbeat of any organisation and it can tell you a few important things. Firstly, the financial health, or liquidity of the business. It will also tell you if you have enough cash for unexpected expenses. Whether you’ve got too much tied up in cash and stocks. Or most importantly whether you’re running the risk of becoming insolvent.

In an ideal world, you’d buy something, make something or provide a service one day. Then the very next day get paid for it. In reality, businesses usually have to wait for many weeks to see a return on an outlay. Working capital is what is required to cover this gap and carry on trading as normal.

Calculating working capital

To calculate the working capital ratio, you need to understand what the current assets and current liabilities of a business are. Current assets are things that can be converted into cash within a year, including cash and invoices. Whilst current liabilities are things that are going to be payable in the next 12 months.

Bank accountsAccounts payable
Stocks & bondsPayroll
Accounts receivableTax
Raw materialsDebts (short and long term)

After dividing the total current assets by total current liabilities you’re left with a ratio. This working capital formula represents company liquidity and the net working capital position of the business. A positive working capital number indicates that the company has sufficient capital to meet its operating requirements and make short term investments. A negative figure indicates that they have a shortfall.

Anything under 1 means that the business needs to take action to improve the situation. They may need to borrow additional funds. Negative working capital could prevent them from investing in growth initiatives or meeting their current liabilities.

Managing your Working Capital

It’s a balancing act between holding too much and too little short-term capital. Working capital will always have a cost attached and therefore should be minimised without impacting the growth of a business. The objective of working capital management is to achieve the right balance of cash flow through the business. Efficient management of working capital includes:

Maintaining an appropriate level of cash or financing facilities, i.e. managing liquidityMaximising accounts payable terms
Minimising the levels of inventory on handMaintaining appropriate short-term borrowings and financing facilities to meet cash commitments
Minimising outstanding accounts receivables

Management processes

In order to properly manage working capital, a number of management processes must work together:

  • Accurate and timely measurement and reporting of the key variables which affect the overall level of working capital (short term liabilities and assets, short term debt)
  • A cash management strategy (eg management of cash and financing facilities to provide cash as and when needed)
  • Strategies to manage accounts receivable and accounts payables
  • Inventory management systems to ensure an appropriate level of inventory is held to meet demand, without over-investment

The combination of these processes should ensure capital is available to allow a business to meet its commitments. And to give them the flexibility needed to take advantage of opportunities as they arise, without over-investing in unproductive assets.

Outstanding debts (receivables) owed has a direct impact on the working capital. It is therefore critical for companies to ensure the collection process is well functioned to avoid a long payment receivables period.

Similarly, inventory levels need to be kept at the optimum level to positively impact on the working capital. Holding too much stock leaves a company vulnerable with no cash being received for the goods.

Creditors (payables) also influence the working capital. The longer it takes vendors to be paid, the longer the company maintains its working capital. The period between payment to the supplier and receipt of customer funds is called the cash conversion cycle (CCC).

Cash Conversion Cycle

The cash conversion cycle is a quick way to understand how soon you should see a return on your investments. How long it will take for the money you’ve spent to come back into the business.

You need to first understand three important numbers.

  • Inventory days - how long stock is sitting on a shelf. Or how long you’ve spent making something.
  • Debtor days - how long it takes you to get paid. It’s in the interest of any business to minimise this as much as possible.
  • Creditor days - how long it takes you to pay your invoices. Conversely, it’s in the interest of the business to maximise this.

Coping with seasonality

Seasonal businesses, such a wholesaler of Christmas decorations or a gardening business may need a higher level of working capital. They'll need to support themselves through the entire year and may well have to purchase stock well before their busy season.

Sources of working capital financing

There are various sources of funding available to companies looking to manage their ongoing cash flow. These include:

Russ Watts

Digi Marketer, responsible for spreading the Waddle word far and wide. Writes the blogs, manages the ads & comes up with ways of making invoice finance sound exciting.