It is also called net working capital. Current assets should turn into cash within about a year and current liabilities have to be paid within a year, so the difference is the cushion between the two. Accounts receivable are often among the largest items, which is why the speed at which customers pay changes how much working capital a business needs.
Working capital formula
Working capital = current assets minus current liabilities
| Current assets | Current liabilities |
|---|---|
| Cash and bank balances | Accounts payable to suppliers |
| Accounts receivable | Accrued wages, taxes and other expenses |
| Inventory | Overdrafts and short-term loans |
| Prepaid expenses | The part of long-term debt due within a year |
Analysts also use a narrower measure, trade or operating working capital, which equals receivables plus inventory minus payables. It leaves out cash and borrowing, so it shows how much money is tied up in trading itself. The working capital ratio, also called the current ratio, divides current assets by current liabilities.
Working capital example
Example. A building supplies wholesaler has annual revenue of $10,950,000, or $30,000 a day. At the year end its current assets are cash of $250,000, accounts receivable of $1,350,000, inventory of $1,200,000 and prepaid expenses of $50,000, a total of $2,850,000. Its current liabilities are accounts payable of $700,000, accrued expenses of $250,000 and an overdraft of $400,000, a total of $1,350,000. All figures are illustrative.
- Working capital. $2,850,000 minus $1,350,000 = $1,500,000.
- Current ratio. $2,850,000 ÷ $1,350,000 = 2.1.
- Trade working capital. $1,350,000 + $1,200,000 minus $700,000 = $1,850,000.
How receivables drive working capital
Receivables hold one day of sales for every day customers take to pay. The wholesaler's days sales outstanding figure is $1,350,000 ÷ $10,950,000 × 365 = 45 days. If customers paid in 35 days, receivables would fall by 10 × $30,000 = $300,000.
Collecting a receivable does not change net working capital by itself, because one current asset turns into another. What changes is how much funding trading needs. Trade working capital falls from $1,850,000 to $1,550,000, and the $300,000 can repay most of the overdraft, which saves interest.
Growth works the other way. If sales rise by 20% while customers, stock and suppliers keep the same number of days, receivables grow by $270,000, inventory by $240,000 and payables by $140,000. The business has to find $370,000 more to fund trading, even though it is selling more.
Positive and negative working capital
Positive working capital means current assets cover current liabilities, and a current ratio above 1 says the same thing. Very high working capital is not always good, because it can mean slow-moving stock, overdue receivables or cash sitting idle.
Negative working capital means current liabilities are larger than current assets. In a business that buys on credit and sells for cash, such as many retailers, or one that bills customers a year in advance, it can be normal, because customers fund the business, as a negative cash conversion cycle shows. In other businesses it can mean trouble paying bills as they fall due.
How to improve working capital
- Collect on time. Invoice on delivery, remind customers before the due date and follow up within days of an overdue invoice.
- Set credit on purpose. Match payment terms and credit limits to each customer's risk instead of giving everyone the same terms.
- Hold less stock. Reorder closer to demand and clear slow-moving lines.
- Agree supplier terms. Longer terms negotiated in the contract raise days payable outstanding without the cost of paying late.
- Finance receivables if you need to. Invoice factoring and early payment discounts bring cash in sooner, at a cost in fees or margin.
Sunbay works on the receivables part of working capital. It connects to your ERP or accounting system, sends reminders by email and SMS before and after the due date, matches incoming payments using ERP data and shows DSO next to receivables aging in its analytics view. Tequipy, which provides IT equipment as a service, cut its DSO by 30% with Sunbay.
Frequently asked questions
How do you calculate working capital?
Subtract current liabilities from current assets. With current assets of $2,850,000 and current liabilities of $1,350,000, working capital is $1,500,000.
Is negative working capital bad?
Not always. It is normal for businesses that collect from customers before they pay suppliers, such as many retailers and subscription companies. Elsewhere it can be a sign that the business will struggle to pay bills as they fall due.
Is working capital the same as cash flow?
No. Working capital is a balance on one date, while cash flow is money moving in and out over a period. They are linked, because a rise in receivables or inventory is cash that has not come in yet, so operating cash flow ends up lower than profit by that amount.
How do receivables affect working capital?
Every day customers take to pay holds one day of sales in receivables. At $30,000 of sales a day, collecting 10 days sooner frees $300,000 that would otherwise need funding.
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