Did you know that working capital can determine how well your business is doing financially?

That’s because working capital assesses your business’ ability to pay what it owes (current liabilities) with what it currently has (current assets). So calculating your working capital gives you an indication of your short-term financial health, ability to clear your debts within a year, and your operational efficiency.

This guide will help you understand your working capital by covering the following topics:

  • What working capital means in business
  • Why working capital matters
  • How to calculate working capital
  • How to interpret your working capital calculation
  • How to calculate how much working capital you need

What working capital means in business

In simple terms, your working capital is the money you could have leftover if you paid all your current liabilities with your current assets.

Current liabilities are debts you have to pay within one year or operating cycle, such as income taxes, accounts payable, and short-term loans. And current assets are valuable items you have and plan to use within the same time frame. Examples of current assets include cash, inventory, accounts receivable, and investments you can sell for cash within a year. 

In short, anything you owe or can sell within a year or operating cycle falls within these two categories. Learn more about how liabilities and assets work in a small business.

Why working capital matters for a small business 

Did you know that 10% of companies fail in their first few years of trading? They don’t fail because they’ve miscalculated the need for a product or service but because they didn’t allow for variations in their working capital. 

As a business owner, you need to consider how you finance your daily operations and stay on top of how much working capital you have at hand at any given time. One key advantage of knowing your working capital is that it helps you foresee financial difficulties. Even the most successful businesses can go bankrupt if they can’t pay their dues. 

Insufficient working capital could cause your business to struggle financially. As a result, you might need to borrow more money to cover expenses and risk making late payments to creditors and vendors. This can lead to a lower credit score and less interest from investors. Banks and other lenders will likely demand higher interest rates for your loans as well.  

The best way to avoid ending up in this situation is to calculate your working capital regularly to know how much you have available to pay what you owe.

How to calculate working capital

You’ll need the right financial data to calculate your working capital, which you’ll find on your company’s balance sheet. Once you have the sum of your total current liabilities and assets, you use the following formula to calculate your working capital:

Current assets – current liabilities = net working capital

Using this formula will help you find your total working capital. For example, if your current assets total £10,000 and your current liabilities total £8,000, your calculation would be:

£10,000 – £8,000 = £2,000 in working capital

You can also choose to calculate your working capital as a ratio to give you a clearer picture of how sufficient your working capital is. For that, you’ll use this formula:

Current assets ÷ current liabilities = working capital ratio

Using the same numbers as above, your calculation would be as follows:

£10,000 ÷ £8,000 = 1.25 working capital ratio

How to interpret your working capital calculation

Ideally, you want your working capital ratio to be above one. The higher the ratio number, the more likely it is that you can honour your short-term financial commitments. 

Having a higher working capital ratio means you can easily pay for your day-to-day operations. The more working capital you have, the less likely you are to need financial support to fund your business growth.

On the flip side, if your ratio is less than one, it means you’ll likely struggle to fund your daily operations and your financial commitments. A working capital ratio lower than one is known as negative working capital. You may be able to get by on that for a while, but generating negative working capital for a prolonged time means you probably need to rethink your spending.

How to calculate how much working capital you need

How much working capital you need depends largely on your business type, operating cycle, and goals for future growth. 

For example, businesses that have physical inventory, like a small shop, tend to need more working capital than those that don’t. That’s because these companies need to pay for raw materials to make the inventory or purchase pre-made items to sell to consumers. 

Some businesses may also need to increase their inventory to accommodate expected increases in demand during different periods. For example, seasonal businesses, like Christmas brands, may require high working capital to ramp up for the busy season leading up to the holidays.

Conversely, if your business provides non-physical products, such as consulting services or software solutions, you’ll likely require lower working capital to run efficiently. 

Your operating cycle also affects your need for working capital. For example, businesses that take a long time to create and sell their products need more working capital to meet their financial obligations during the process. 

Additionally, your business goals are another vital factor that determines how much working capital you need. For example, you’ll need much less working capital if you’re happy with your current company size and just want to maintain it rather than grow.

Keep track of your working capital easily with Countingup

Working capital is an important part of financial management, which can be stressful and time-consuming when you’re self-employed. That’s why thousands of business owners use the Countingup app to make their financial admin easier. 

Countingup is the business current account with built-in accounting software that allows you to manage all your financial data in one place. With features like automatic expense categorisation, invoicing on the go, receipt capture tools, tax estimates, and cash flow insights, you can confidently keep on top of your business finances wherever you are. 

You can also share your bookkeeping with your accountant instantly without worrying about duplication errors, data lags or inaccuracies. Seamless, simple, and straightforward! 

Find out more here.