What Is Working Capital And How Do You Improve It?

What is working capital?

Working capital is a business’ current assets minus its current liabilities. Current assets are assets that can be easily converted into cash within a year. Similarly, current liabilities are expenses that must be paid within a year. Working capital is, therefore, a measure of a company’s liquidity.

Once you are familiar with working capital in business, you will be able to tell the various types of working capital apart. These are:

• Permanent working capital: Also called fixed working capital, this is the minimum amount of current assets a business needs at all times to run its operations and cover short-term liabilities. This minimum amount can vary, depending on business size and industry. The larger the business, the more the capital requirement. Also, industries that have longer production cycles or take longer to sell their inventory need a higher permanent working capital compared to industries with a quick inventory turnover (such as retail businesses).
• Regular working capital: This is the minimum amount required to run day-to-day operations (wages, raw materials, overheads, etc) under normal conditions.
• Reserve working capital: The opposite of regular working capital, reserve working capital is what a company sets aside for emergencies and unexpected circumstances such as natural disasters, strikes, and inflation.
• Seasonal working capital: Businesses that experience seasonal fluctuations usually keep additional funds to cover the extra costs incurred during peak seasons. This is called seasonal working capital.
• Special working capital: Another type of variable working capital, this is a fund set aside for special circumstances such as a new product launch, marketing campaign, or unforeseen accident.
• Gross working capital: This is the sum of a company’s current assets before accounting for current liabilities.
• Net working capital: This term is often used interchangeably with working capital. However, some experts make a slight distinction between working capital and net working capital. This distinction is reflected in the formulas for net working capital discussed below.

Understanding working capital

What does working capital mean for business?

Well, it is first and foremost an indicator of a company’s short-term liquidity. If a business has enough working capital, it means it can afford to run operations and meet any short-term obligations such as taxes and interest payments. Businesses need a healthy working capital to stay solvent.

Second, working capital serves as a measure of operational efficiency. If a company has adequate working capital, it is capable of paying it's operating expenses such as paying salaries, buying materials and supplies, purchasing inventory, and meeting all its financial obligation in the short run. When a company has adequate funds, it usually means there is some money left over that can be set aside for contingencies or to invest back in the business.

With a healthy working capital, a business has the resources to fund its growth without the need to borrow. And if it does need a loan, it will be much easier to qualify for one with good working capital figures.

Finally, a healthy working capital is a safety cushion that helps business weather unanticipated challenges and economic challenges.

How to calculate working capital?

The working capital formula is:

Working capital = Current assets – Current liabilities

Current assets are a company’s most liquid assets while current liabilities are debts due within the year. They include:

Both working capital components – current assets and current liabilities – are found in the company balance sheet. The balance sheet is divided into two sections – the first section lists all assets, including current assets and non-current assets, while the second section lists all liabilities (current and non-current) as well as shareholders’ equity. Non-current assets are excluded from the working capital calculation as these cannot be easily converted into cash. It is the same for non-current liabilities as these don’t have to be paid within a year.

While the formula ‘Working capital = Current assets – Current liabilities’ is widely used, there are two variations to this formula, primarily due to the distinctions associated with the meaning of net working capital. The first alternative to net working capital formula is:

Net working capital = Current assets (less cash) – Current liabilities (less debt)

The second alternative formula is even more narrowed down:

Net working capital = Accounts receivable + Inventory – Accounts payable

Working capital example

Here's how one calculates working capital using the formula 'Working capital = Current assets – Current liabilities'.

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Limitations of working capital

1. Working capital fluctuates a lot and can change daily. For example, a long-term loan turns into a current liability in its final repayment year while a fixed asset such as land or property turns into a current asset when its sale is scheduled in the near future. What this means is that by the time working capital data is compiled, the figures might already have changed drastically, leading to an inaccurate reading of the company’s liquidity position.
2. Assets can be devalued, which triggers changes in working capital that are outside the control of the company. Some common examples of asset devaluation include inventory turning obsolete and accounts receivables being written off due to the customer’s inability to pay. Both instances lead to a reduction in working capital, which might be difficult to make up for.
3. Working capital is heavily influenced by external factors that are, once again, out of the company’s control. Economic downturns, industry trends are some such factors.
4. Working capital does not account for cash flow timings, which significantly impacts the ability to service short-term financial obligations.
5. Working capital focuses only on short-term liquidity. It is, therefore, not a reliable indicator of overall financial health.

What does positive working capital mean?

When the difference between current assets and current liabilities is positive, it means a business has the resources to meet its financial liabilities in the short run and still have some cash left over. A positive working capital enables companies to invest in growing their business, for instance by expanding into a new market, launching new product lines, or buying new equipment.

All businesses strive for positive working capital so that there is extra cash to fund expansion plans and take care of contingencies. But if working capital is too high, it is not necessarily a good thing. A consistently high working capital figure is problematic for it could mean that the company isn’t investing its excess cash, which indicates that it isn't not growth-oriented. Or, it could mean that it has too much inventory in stock, which is typing up cash and reducing cash flow.

What does negative working capital mean?

Working capital is negative when a business’ current assets cannot cover its current liabilities. It means that the company has more debts than resources and is struggling to pay its suppliers and creditors. Negative working capital indicates inefficient use of current assets and can become a crippling problem if not corrected. A prolonged spell of negative working capital makes businesses vulnerable to taking on more debt that they can repay, becoming less creditworthy, and eventually having to shut down altogether.        

However, negative working capital is not always as bad as it seems as there could be a valid reason for it. Capital-intensive businesses (automobile companies, steel manufacturers, etc) might struggle with negative working capital at times because they have longer payment periods and are unable to raise cash quickly. Similarly, businesses that are just starting out will likely experience negative working capital due to heavy initial investments (buying equipment, inventory, etc).

How can a business improve its working capital?

Here are six ways to improve working capital:

1. Increase current assets by cutting unnecessary expenses and saving cash, selling fixed assets to turn them into cash, and so on.
2. Avoid taking on more working capital loans than necessary. A working capital loan – which is specifically meant for funding everyday operations – is relatively easy to obtain. But it is usually expensive with high interest rates, which has a detrimental impact on working capital. Such loans are also directly linked to the borrower’s personal credit, which means that any missed payments will hurt their credit score.
3. Reduce short-term debts via debt refinancing, thereby turning them into long-term debts. This helps build up cash reserves without overburdening current liabilities.
4. Cut down on extending credit to customers who are likely to default on payment. This will bring down bad debt and write-offs. However, the process requires careful analysis or it can hurt customer sentiment.
5. Take advantage of early payment discounts and incentives when paying suppliers and lenders.
6. Avoid overstocking to free up cash and lower the chances of writing off inventory.

Does working capital change?

Yes it does, even on a day-to-day basis. The figures captured on the company's balance sheet on a specific day might be quite different at another time. Multiple factors can contribute to these changes. Large purchases, such as equipment and property, lower working capital. So does a short-term loan. On the other hand, working capital goes up when invoices get paid or when inventory management is optimised to reduce overstocking. Businesses that experience seasonal fluctuations in sales might see drastic changes in their working capital data from month to month.

Working capital management

To improve working capital and increase efficiencies, businesses must invest in a robust and well thought out working capital management strategy. Working capital management involves monitoring current assets and liabilities and quantifying how efficiently they are deployed with the use of three ratios – the working capital ratio, collection ratio, and inventory turnover ratio.

Working capital ratio

It is also called the current ratio. To calculate it, you need to divide current assets by current liabilities. The working capital ratio measures a company's ability to fulfil short-term financial obligations. A ratio below 1 indicates inability to cover current liabilities. A ratio between 1.2 and 2 is considered healthy while anything above 2 is taken to mean that the company isn’t utilising its current assets efficiently.

Collection ratio

This ratio, which is also called days sales outstanding (DSO), assesses how well a business manages its accounts receivable. To calculate collection ratio, divide average accounts receivable by total credit sales value for a given period, then multiply the result by the number of days in that period. This ratio tells you how many days on average it takes to collect payment on a sale. The higher the DSO, the longer the collection time, which in turn signals a negative impact on cash flow.

Inventory turnover ratio

This metric helps businesses stock enough inventory to keep up with demand while avoiding overstocking. By dividing cost of goods sold by average inventory, the inventory turnover ratio reveals how long it takes for inventory to be sold and replenished. Businesses aim for a higher ratio as it indicates swift sales and effective inventory management.

Working capital cycle

In addition to the three ratios, working capital management uses a fourth metric called the working capital cycle. This metric works out the time taken to turn a business’ total working capital (current assets – current liabilities) into cash. This is the formula to calculate working capital cycle:

Working capital cycle = Inventory days + Receivable days – Payable days

Here, inventory days is the time it takes to sell inventory, receivable days is the number of days it takes to receive payment for the goods sold, and payable days is the time taken to pay suppliers for the raw materials received.

A company's working capital cycle counts time from when the company pays its suppliers for raw materials to when it receives payment for its finished goods. During this period, its cash resources are either set aside to meet financial obligations or yet to be turned into cash. The figure arrived at through the calculation represents the number of days the business is out of pocket. Therefore, the lower the figure, the better it is for business.

For example:

Inventory days = 60 days

Receivable days = 30 days

Payable days = 75 days

Working capital cycle = 60 + 30 – 75 = 15 days

This calculation shows that the company's cash is tied up for 15 days. 

This is an example of a positive working capital cycle. A negative working capital cycle, although rare, can happen at times and is highly desirable because it means that a company is collecting payments faster than it is paying off its bills.

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Working capital ratio vs quick ratio vs current ratio

The working capital ratio and current ratio are one and the same. They assess if a company is capable of paying for its short-term liabilities by using its current assets. Like the working capital ratio or current ratio, the quick ratio is another metric that measures liquidity. However, what sets it apart from the other is that it only accounts for the most liquid assets that can be easily converted to cash, leaving out inventory and prepaid expenses. The formula to calculate quick ratio is:

Quick ratio = Current assets excluding inventory and prepaid expenses / Current liabilities

Also called the acid test ratio, the quick ratio provides a more precise measure of liquidity. It is especially suited for companies with slow inventory turnover. In comparison, the working capital ratio provides a more comprehensive reading of overall liquidity.

Optimise working capital management with Aspire

Maintaining healthy working capital requires effective accounts payable and accounts receivable management. Aspire can give your business the edge it needs with automated processes that help increase cash flow and reduce over-dependence on working capital. With our Accounts Payable feature, you can upload multiple invoices in seconds, save time with bulk payments, and streamline your approval processes – all in-app. Meanwhile, our Accounts Receivable platform can boost your cash reserves by ensuring you get paid 14 days faster on average.