Ah, working capital, another financial term that mystifies many.
However, working capital is actually pretty simple to understand once you break it down.
Working capital is the value left over after all of your short term debts have been met by your available sources of cash or cash equivalents.
This is done by subtracting your current assets from your current liabilities.
Working capital can be positive or negative, as your current assets can be lower than your current liabilities. However, as we’ll see, this isn’t a great situation to be in.
The value of your working capital highlights whether you have enough liquid assets to pay off short term debts. When investors and CFOs are inspecting a business’ health and level of risk, this is one of the metrics they’ll look at closely.
What is it about working capital that makes it so important?
Today we’ll learn:
- What current assets & current liabilities are
- How to calculate working capital with an example
- What positive and negative working capital mean for a business
- And finally, what impact your industry has on your working capital
Let’s start with a quick recap of current assets and liabilities.
What are current assets?
Current assets are reserves or property of the business that can easily be exchanged for cash, or are already realised as cash or cash-equivalents. Typically they must be able to be converted into cash within one year to be classified as “current”.
Current assets include but are not limited to:
Accounts receivable (money owed by customers)
Inventory (stock you have ready to sell)
What are current liabilities?
Current liabilities are monies that a company will owe within one year, making them short term debts. They often include taxes, wages payable, accounts payable etc.
An indicator of a business’ ability to pay these debts is known as the current ratio. The current ratio is a way for investors to weigh up the risk in the business, it is calculated by taking the current assets and dividing them by the current liabilities.
The current ratio is expressed, as the name suggests, as a ratio. Comparatively, working capital is an absolute amount.
The current ratio is also a different formula to working capital. They both use the same figures, but current ratio divides whereas working capital subtracts.
You can read more about the current ratio in this article.
How to calculate working capital
Working capital, as I explained earlier, is actually a pretty simple equation to get your head around. Let’s take a look.
Working capital is your current assets minus your current liabilities.
So the equation looks like this:
Now let’s look at a working example (pun intended).
Below is a snippet of a coffee shop business’ balance sheet we created in Brixx.
The arrows in the image point towards the current assets and current liabilities.
Their current assets equal £188,249.64
Their current liabilities equal £34,776.83
Putting it all together…
£188,249.64 – £34,776.83 = 153,472.81
Working capital of 153,472.81 means the coffee shop has positive working capital and puts the business in a great position to grow. In the next section, we’ll be discussing what this means for business.
It’s important to realise that working capital can fluctuate depending on the season and industry. For example, a ski rental shop will have much greater working capital in their high season vs their low season.
What does it mean to have a positive working capital?
If we look at the example from the previous section. The value of this coffee shop’s current assets are greater than their current liabilities.
But what does this mean exactly, and what can they do now?
If a business’ current assets are greater than current liabilities, this indicates that the risk that they won’t be able to pay short-term debts is low.
They have enough current assets to cover their debts.
Since our coffee shop example is easily capable of meeting it’s short-term debts, it’s excess working capital could be invested into the business’ future.
This could provide opportunities for expansion, new equipment, or a new project, like starting a delivery service to local offices, for example.
Working capital, unlike the current ratio, shows an absolute value rather than something proportional. This working capital for the coffee shop is good for them but maybe risky for a larger business, working capital needs to be judged relative to the business’ other finances.
In fact, if a company’s working capital is too high, it might be seen to be missing out on opportunities for growth.
Having too much underutilised working capital, may mean that the business can cover its debts easily, but could also indicate that the business’ potential growth could be higher than it is.
It’s important to remember that positive working capital can’t always be achieved by the business alone.
Sometimes outside funding is required.
This is almost certainly the case for startups in their first few years of operation since their revenue streams will still be growing.
Although you can increase working capital with outside funding, if you borrow money to do this then you are also adding to the business’ liabilities.
Another option is to sell equity in the business instead – this means there’s no liability, but does have other implications for the business, such as dividends to pay out each month.
So, we’ve established what the implications are of having positive working capital, but what if your current assets are less than your current liabilities?
What does it mean to have negative working capital?
If your current liabilities outweigh your current assets, then you will have a negative figure, this is known as negative working capital.
So what does this mean for your business?
Negative working capital is generally seen as a bad thing. On the surface your short term available assets simply won’t cover your short term debts. It means you might have salaries to pay and not enough money to pay them!
Of course, this can be resolved through further sales coming through or taking out short-term funding sources.
However, this risk could turn into a real problem. Not being able to pay your suppliers, employees and tax bills can be highly disruptive if it catches you off guard.
Consequently, an inability to pay short term debts will stunt the business’ overall growth in both the short and long term. In contrast to positive working capital, you just don’t have free cash to invest into growth. It’s all tied up in paying the running costs of the business, firefighting and scrambling to pay bills.
It can also raise doubts over a business’ operating procedures and its business model. It could indicate that revenue streams are not profitable enough or that the business needs to find a way to reduce its costs.
This puts the company in a tricky situation of potentially needing to regularly raise funds from other sources, such as investors or the bank.
An option for businesses in this situation is to opt for a working capital loan.
Working capital loans are often used by businesses to help cover their running costs where they run into cash flow problems.
This is often about timing.
They might forecast strong sales for a period, but if they don’t receive the cash from sales in time to pay their bills, they will need short-term funding to bridge the gap.
The earlier your spot this the better, applying for a loan is far easier if you have identified in advance when you’re likely to need it. Maintaining an up to date cash flow forecast can really help with this process.
Even if your working capital is positive you might still consider further working capital loans to help smooth out cash flow and invest in the business (marketing, purchases, new hires etc).
You might have noticed that earlier I said “negative working capital is generally seen as a bad thing”. There are cases where negative working capital isn’t so problematic, and is just the nature of certain industries.
How working capital requirements are affected by different industries
Having periods of negative working capital isn’t always bad.
The key word there is periods. Some industries are more likely to experience times of negative working capital than others.
Industries such as retail or food can afford to have negative working capital, as payments from customers come through very quickly. This means that periods of negative capital aren’t as much of an issue.
Money owed to you from customers is shown on the Balance Sheet in the ‘accounts receivable’ line. When payments happen immediately, the money can move in and out of your bank account before it has time to be recorded as a current asset.
This is in contrast to an engineering business where payments may be held up in accounts receivable for months.
Therefore whilst it isn’t always bad to have periods of negative working capital, in order to invest and grow a business positive working capital is necessary.
Working Capital Recap & Final Thoughts
Let’s briefly recap what we’ve covered in this article:
- Working capital is a measure of how well a business can pay off its short term debts with its liquid assets.
- It is important for investors to analyse as it gives a good indication of how well a business can manage its cash flow and whether it has potential to grow.
- Working capital is calculated by deducting current liabilities from current assets.
- If the figure is positive you have positive working capital, if it is negative, you have negative working capital.
- Depending on the industry and cash payment cycles, having periods of negative working capital isn’t always bad. However, having positive working capital is necessary for a business to grow.
Whilst your working capital gives you an indication of risk, it’s not the complete picture.
A forecast of your cash flow and profit & loss is needed to see upcoming profitability and cash.
These will help inform whether your working capital situation is a true risk or not.
You can learn more about the cash flow and profit and loss forecasts with our handy guides below.