Working Capital Explained: Formula, Ratio, and Management Basics

Working Capital: What It Is, How It Works, and Why It Matters

Small and mid-sized businesses (SMBs) are the backbone of the US economy. According to the U.S. Small Business Administration Office of Advocacy, 99.9% of all businesses in the country fit into this category. Small businesses alone employ 62.3 million people, and their economic activity makes up 43.5% of the US GDP.

As an SMB owner or financial leader, your job is to help your business succeed. While success is subjective and hard to quantify, one measurable way to determine how well your business is doing is calculating your working capital.

Working capital is simply a practical snapshot of your liquidity and your ability to cover debt obligations in a 12-month timeframe. It’s not a static accounting figure but a dynamic management process that can help your business grow.

Today, we’ll dive into working capital, show how to calculate it, and explain where working capital ratio (or current ratio) fits into the picture. We’ll also explore ways you can avoid common working capital pitfalls while maximizing your liquidity in the process.

What Is Working Capital?

Working capital is the money you have on hand—or could have on hand quickly—to cover any short-term operational expenses, unexpected costs, or crises that may arise. It’s a financial metric that lets you, your stakeholders, and potential investors know whether your current assets (e.g., cash, cash equivalents, inventories, finished goods, and accounts receivable) can cover your current liabilities (e.g., accounts payable, debts, taxes, and salaries and wages).

Working capital highlights your short-term resilience and operating flexibility, offering insight into your inventory management and accounts receivable efficiency as well as your growth capabilities.

How to Calculate Working Capital

Calculating working capital begins with your balance sheet, which provides your company’s assets, liabilities, and shareholders’ equity at a specific point in time. These components make up the working capital formula:

Working Capital = Current Assets – Current Liabilities

Let’s look at an example. Say Business Z has $150,000 in current assets and $70,000 in current liabilities. Using the working capital formula, we see that the business’s working capital, including their cash, cash equivalents, and liquified assets, is $80,000.

This is a positive working capital, but working capital can also be negative. A positive working capital means a business’s current assets meet or exceed its current liabilities, suggesting that the organization is financially solvent in the near term. A negative working capital is the converse, indicating that the business may have trouble paying off obligations, putting it on shaky financial ground. (May is the operative word here because negative working capital does not always equal financial distress. More on this below.)

Working Capital Ratio: What It Tells You About Liquidity

Working capital is the gold standard for showing how well you can pay your day-to-day bills and how much you have left over for further investments, but there’s another, more detailed metric that can be used to measure liquidity, compare performance, and monitor risk: the working capital ratio or current ratio.

Current ratio, which is calculated by dividing your current assets by your current liabilities, measures your liquidity in terms of a ratio. According to Stripe, the current ratio “tells you how many dollars of current assets you have for every dollar of current debt.”

Here’s the current ratio formula:

Current Ratio = Current Assets ÷ Current Liabilities

Using the numbers from the example above, we divide $150,000 by $70,000, giving Business Z a current ratio of 2.14. So, for every $1.00 the business owes, it has $2.14 in assets.

A business with a ratio of 1 or more is typically considered to have stable liquidity, while a ratio below 1 may indicate cash flow concerns. At the same time, a ratio that is very high compared to industry peers’ may mean a business has too much cash or inventory and isn’t investing wisely.

This brings us to an important note: different industries view current ratio differently. For example, with distribution companies that turn over their inventory rapidly, a low current ratio may be of no concern, but for companies that keep large amounts of inventory on hand, it would be.

How to Increase Working Capital (Even When Cash is Tight) and Improve Efficiency

To improve working capital for your business and secure short-term stabilization, consider the following options:

• Increase current assets and decrease liabilities
• Automate invoices to accelerate the cash conversion cycle (the time in days it takes your business to convert your inventory/resources into cash), reduce Days Sales Outstanding (DSO), and decrease manual errors—which will speed up customer payments and increase cash flow.
• Use data analytics for cash flow forecasting to accurately predict inflows and outflows and minimize shortages.

To avoid recurring margin damage or operational risk, make sure you’re being consistent in your pricing policies and ensuring accurate inventory (e.g., ordering enough to avoid stockouts but not too much, which can result in overstocking).

Working Capital: Common Pitfalls, Limitations, and Misconceptions

As helpful as working capital is as a financial metric, keep in mind that it does have limitations. For example, working capital is a “snapshot” of your business’s liquidity at a specific time. It’s not a changeless view of your business, and it can’t account for the rapid day-to-day fluctuations that happen in any organization.

Working capital also doesn’t specify how your current assets are broken down. For instance, if your assets are mostly in accounts receivable or in inventory and if your customers don’t pay or the inventory doesn’t sell, then your assets are not necessarily assets and may even become liabilities, putting your liquidity status in question.

Additionally, working capital can cause misconceptions, such as the idea that negative working capital is automatically “bad.” Negative working capital can have various causes, from businesses still being in their development stages to investments in seasonal inventory. Some businesses sell inventory quickly and pay vendors later, making a negative working capital a mark of efficiency, not insolvency. In these cases, negative working capital is either temporary or to be expected.

So, while working capital is critical for knowing whether your business can meet short-term commitments or not, it is a static metric that must be viewed in light of industry-specific benchmarks. Using working capital in conjunction with current ratio will provide a fuller picture of your business’s true liquidity.

Conclusion: Working Capital Management in Practice

Managing your working capital—also known as working capital management—is how you keep track of current assets and liabilities, ensuring you can pay your daily expenses and keep cash flowing. While strong working capital management sets you up for responsible, long-term growth, it’s a process that has a lot of moving parts. To make it smooth and seamless, you’ll want to invest in the right tool.

In this case, the right tool is a comprehensive ERP solution, like Acumatica. Acumatica delivers advanced, integrated financial and inventory management applications that put your accounts receivable, accounts payable, and inventory data at your fingertips. With Acumatica’s cash management system, you can easily track your company’s cash conversion cycle (CCC), which measures, in days, how long your cash is tied up in paying for inventory and collecting cash from customers, using Days Inventory Outstanding (DIO), Days Sales Outstanding (DSO), and Days Payable Outstanding (DPS).

Having these advanced financial features in one complete system empowers you to manage your working capital effectively and will help guide your next steps as you optimize cash flow for long-term, sustainable growth. To learn more about how Acumatica can take working capital management from time-consuming and painful to efficient and effortless, contact our experts today.

FAQs About Working Capital

Is working capital the same as cash flow?

Working capital and cash flow are not the same, but they are connected. Changes in cash flow (e.g., the amount of money coming into and going out of a business) will impact your working capital. For example, if cash flow slows down, you may need to dip into your working capital to cover short-term obligations. Positive cash flow, on the other hand, increases your liquid assets and improves your working capital.

What is a good working capital ratio for a business like mine?

A good working capital ratio for an SMB like yours is, according to Investopedia, between 1.5 and 2. “A ratio of 1.5:2 is interpreted as indicating that a company is on solid financial ground in terms of liquidity” but “an increasingly higher ratio above two isn’t necessarily better. A substantially higher ratio can indicate that a company isn’t doing a good job of employing its assets to generate the maximum possible revenue.”

How often should we review working capital?

Regular, consistent reviews will let you know whether you have enough liquidity to cover your near-term expenses. At a minimum, you should be calculating your working capital once a month, though weekly monitoring of accounts receivable, accounts payable, and inventory can help you flex in the face of changing conditions.