What is working capital? And how do you find out yours?

It can be tricky to see the whole financial picture of your business. With short term debts like utility bills, wages, and taxes going out of your business while sales are coming in – wouldn’t it be great to have a clear indicator of your financial health? 

Working capital is just that. And while it may sound like a corporate buzzword, working out your working capital can be beneficial for businesses of all sizes. So what is working capital and why is it important? And how do you work it out? Read on to find out.

What is working capital? 

Working capital, sometimes called net working capital (NWC), is a budgeting metric that helps you understand the financial health of your business. It shows the amount of money you have readily available in your business to cover your short-term costs after paying off your short-term debts.

Put simply, it helps you know how much money you have left once you’ve paid for everything you need to. To figure out your working capital, there’s a few terms you’ll need to understand to get started.  

Liquid assets 

A liquid asset is something you own in your business that can be quickly turned into cash without it losing much value. 

Physical cash, bonds, stocks, and money in easy access bank accounts are all considered liquid assets. Things like company cars, specialist equipment, and property wouldn’t be because they’re more difficult to sell quickly. 

Liquidity 

Liquidity is a term that describes the type of assets you have in your business and how easily they can be turned into cash. Your business can be in a state of high liquidity or low liquidity. 

• high liquidity means you have lots of liquid assets in your business that can be exchanged for cash quickly if you need to 

• low liquidity means the opposite, that you have lots of assets with a low liquidity that are more difficult to sell quickly 

Current assets and liabilities

These are the two key metrics to work out your working capital: 

• your current assets are items in your business like cash, inventory, equipment, and property that have value 

• the money and services you owe are your current liabilities, like wages, tax, and bills

How to use a working capital formula 

You can find out the working capital of your business through a simple formula. The basic formula is: your current assets – current liabilities = your working capital. 

So if the current assets in your business are worth £100,000 and your current liabilities are £80,000, your working capital would be £20,000. 

The example above would be described as a positive working capital because the number is above zero.

It’s when businesses end up with a negative working capital that something needs to change. 

Why understanding your working capital is crucial 

For small businesses, maintaining a steady cash flow is crucial. Figuring out your working capital is a good pulse check on how easily you’ll be able to meet your financial obligations.  

It can be easy to lose sight of how your business is doing financially because you can have lots of incomings and outgoings, which doesn’t give you a clear idea of what’s left. Not knowing or misjudging your working capital can lead to a variety of issues for your business like: 

• failing to pay your suppliers 
• falling behind on your bills
• increasing your debt 

You can also view your working capital as your safety net. As it’s technically additional income, you could save it for a rainy day and add it to your sinking fund. With many businesses still feeling the effects of Covid-19 and the cost of living crisis, having extra cash for an emergency could help you get through a rough patch.   

But understanding your working capital isn’t only about avoiding difficult financial situations – it’s also about working more efficiently, and seeing what headroom you have for growth. 

You could plan to use 10 per cent of your working capital on investing in new equipment, for example. Or if you’re looking to sell your business, a healthy working capital is one of the financial measures potential buyers will be looking for.  

So understanding and improving your working capital is a good idea for most businesses, regardless what stage of growth you’re in. 

How to improve your working capital

There are a few different ways you can improve your working capital that aren’t just about making more money. There are a few strategic changes you can make that could help you keep a positive working capital, like: 

• managing stock – make sure you’re not overstocked or understocked, this way you’ll avoid spending too much in one go and protect your cash flow
• negotiating longer payment terms –  with your regular suppliers, sometimes it’s possible to spread your costs over long periods to reduce your short-term debts
• checking credit scores – taking the time to check the credit score of a business can help you avoid late payments and keep a steady cash flow    

Do you know your working capital? Let us know in the comments below.

More useful articles for small business owners 

• What is bookkeeping? 
• Do you need to hire an accountant? 
• 7 best business loans compared
• What is public liability insurance?

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