How to calculate working capital
Working capital = Current Assets minus Current Liabilities. Current assets include trade debtors (money owed to you by customers), stock, and cash. Current liabilities include trade creditors (money you owe to suppliers), short-term loans, tax liabilities, and accruals.
A positive working capital figure means your short-term assets exceed your short-term liabilities, giving you a buffer. A negative figure means your current liabilities exceed your current assets, which is a warning sign that the business may struggle to meet its obligations.
Working capital vs cash flow
Working capital and cash flow are related but not identical. A business with high working capital can still run out of cash if most of that working capital is tied up in stock that is not selling, or in debtors who are not paying. Managing the components of working capital individually, particularly debtor days, stock turn, and creditor days, is as important as monitoring the aggregate figure.
How to improve working capital
There are three main levers for improving working capital: reducing the time it takes to collect customer payments (debtor days), extending the time you take to pay suppliers (creditor days), and reducing the amount of capital tied up in stock.
- Reduce debtor days by tightening credit terms, improving collections, and using invoice finance
- Extend creditor days by negotiating longer payment terms with suppliers
- Improve stock turn by reducing excess inventory and improving demand forecasting
- Access a working capital facility (invoice finance, overdraft) to bridge seasonal or structural gaps
Working capital funding
When working capital requirements exceed what the business can generate internally, external finance is required. Invoice finance is the most common working capital solution for B2B businesses because the facility scales with turnover and is secured against the very assets (debtors) that represent the working capital need.
Worked Example
A wholesale business with £500,000 in trade debtors, £120,000 in stock, £30,000 cash, £280,000 in trade creditors, and £50,000 in HMRC liabilities.
- Current assets: £500,000 + £120,000 + £30,000 = £650,000
- Current liabilities: £280,000 + £50,000 = £330,000
- Working capital: £650,000 - £330,000 = £320,000
A working capital figure of £320,000 appears healthy, but £500,000 of the current assets are trade debtors. If debtor days are long or customers are slow to pay, the business may face a cash squeeze despite the positive working capital figure. This demonstrates why invoice finance can be valuable even for businesses with technically positive working capital.
Frequently Asked Questions
What is a good working capital ratio?
A working capital ratio (current ratio) of 1.5 to 2.0 is generally considered healthy. Below 1.0 means current liabilities exceed current assets, which is a potential solvency concern.
Can a profitable business have negative working capital?
Yes. A business can be profitable on an accruals basis but have negative working capital if it has significant short-term liabilities falling due before its debtors pay. This is a common cause of business failure.