What is working capital?

Understanding working capital is essential for operating a start-up business, funding growth and expansion, and preventing it from failing.

Managing your start-up’s working capital from day one could help make your business more resilient during unstable economic times, such as rising inflation and cost-of-living pressures.

What is working capital?

Working capital is the difference between your business’s current liabilities and current assets.

It’s often used to measure your start-up’s short-term financial health.

This is because it’s the money you have available to fund your business’s day-to-day operations over the next 12 months.

Current assets

These are the resources that your business can convert into cash within the coming year.

These may include:

• cash in current and savings accounts
• accounts receivable
• short-term expenses
• pre-paid expenses
• stock and inventory.

Current liabilities

Current liabilities are debts or obligations your business must pay within one year.

These may include:

• rent, utilities, and supplies
• accounts payable
• accrued expenses
• accrued income taxes
• dividends payable.

How is working capital different to cash flow and liquidity?

Working capital, liquidity, and cash flow are all financial terms that relate to a business’s financial health, but they focus on different aspects.

• working capital – the difference between your business’s assets and liabilities, showing the funds available for day-to-day operations.
• liquidity – how easily a business can convert assets into cash, showing its ability to pay bills when they are due.
• cash flow – tracks the movement of cash in and out of the business, showing how well a company generates cash to cover its debts, invest in its operations, and provide returns to its shareholders.

Together, these metrics provide a comprehensive view of your business’s financial health.

Why is working capital important?

Working capital is critical to your business for several reasons.

1. Allows for day-to-day operations

Working capital is used to cover the everyday expenses of running a business, such as paying employees, purchasing inventory, and covering utilities bills.

It means a business can operate smoothly without interruptions.

2. It enables you to pay bills on time

Adequate working capital can prevent bills from being delayed.

As delays could harm your business relationships and reputation, this is important for your credibility with stakeholders.

3. It helps business stability

Adequate working capital helps a business remain stable during revenue fluctuations, unexpected expenses, or tough economic times.

It provides a financial cushion to handle emergencies or downturns without resorting to emergency loans or drastic cost-cutting measures.

4. Improved credit score

A healthy level of working capital can improve a business’s credit rating.

This can help secure loans or attract investors, as it indicates the business is financially sound and capable of repaying debts.

5. It can help a business grow

Working capital is essential for start-ups looking to grow.

Expansion may require upfront cash to invest in additional inventory, marketing, staffing, and technology.

For example, a larger company with an increased customer base may have a bigger need for suppliers, which could involve paying bills ahead of customer payments.

The cycle of paying suppliers before receiving payment from customers is typical in business, and having strong working capital can ensure that you can manage this cash flow gap.

How to calculate working capital

To calculate your working capital, subtract your total current liabilities from your current assets.
The formula is:

Working capital = current assets – current liabilities

For example, if your business has £500,000 in current assets and £400,000 in current liabilities, your working capital is £100,000.

There are two different types of working capital – positive and negative:

• positive working capital – this means a business has more current assets than current liabilities, indicating it can more easily cover its short-term debts and continue operations smoothly
• negative working capital – this means a business’s current liabilities exceed current assets, suggesting potential cash flow issues and difficulty meeting short-term financial obligations.

Calculating your working capital ratio is necessary to understand how well your business will be able to handle tough financial or economic times.

To do that, divide your current assets by your current liabilities.

The formula is:

Working capital ratio = current assets ÷ current liabilities

For example, if your business has £500,000 in current assets and £400,000 in current liabilities, your working capital ratio is 1.25.

A ratio of between 1.2 and 2.0 is considered good.

A ratio below 1 indicates your business could face potential financial problems and may not have enough money to pay the bills.

However, a high working capital ratio isn’t necessarily positive.

It might indicate that your business is not investing enough of its cash in growth.

Deciding how much working capital your business needs

Having at least three to six months’ worth of operating expenses as working capital can provide a stable financial foundation for your start-up.

However, the specific amount of working capital your start-up needs can depend on various factors, including:

Type of business

The type of business you operate influences how much working capital you need.

For example, retail businesses typically require a significant amount of working capital to buy stock before selling it.

In contrast, software companies may have fewer requirements for working capital as they do not deliver a physical product.

Attitude to growth

Your attitude to business growth can also impact your working capital.

A business owner looking to scale may require more working capital than one happy to keep their company at its current size.

Seasonality

Some businesses, such as tourism companies, have seasonal demands, so they will require more working capital at different times of the year.

To ensure financial stability, you need to predict your most and least profitable months based on the type of business you are running.

This will allow you to be prepared with enough working capital for different demand levels.

Length of the operating cycle

An operating cycle (also known as the cash conversion cycle) is the time it takes for a business to turn its inventory or stock into sales.

The length of this cycle will dictate how much working capital you need.

Calculating the average length of your start-up’s operating cycle could help you create more accurate financial forecasts and budgets.

Unexpected expenses

Having a buffer for unforeseen costs, such as equipment repairs or emergency expenses, could be crucial for maintaining healthy working capital.

Planning for contingencies ensures your business can handle surprises without disrupting daily operations.

Credit terms with suppliers and customers

The credit terms you negotiate with suppliers and offer to customers could significantly affect your working capital needs.

Longer supplier payment terms can free up cash, while extended credit to customers might increase your working capital requirements.

How to manage your working capital

You may want to implement measures that keep your working capital ratio between 1.2 and 2.0.

To improve your start-up’s working capital, you could take several steps:

Maintain your cash reserves

If you add to your start-up’s cash reserves regularly, you could have a useful financial cushion to fall back on.

This could help you navigate any unexpected expenses or a drop in revenue.

You could regularly set aside a portion of your profits – or as much as possible – to create a safety net.

This could mean you have the money to cover immediate priorities without disrupting your day-to-day operations.

Inventory management

Carefully managing your inventory could help improve your working capital, as unsold inventory sitting in storage eats into your liquidity.

It could add extra costs, such as storage and insurance, and you could risk price changes and inventory deterioration.

To avoid this, consider keeping the minimum possible amount of stock without impacting your sales.

You could also adopt the Just-In-Time (JIT) inventory system, which involves receiving materials from a supplier only at the time they are needed.

This process could cut expenses, as you only pay for the required resources and storage space costs could also be reduced.

Inventory management software can help to better track your orders, deliveries, and sales to avoid overstocking.

Reduce your expenses

It can be a good idea to regularly analyse your expenses to see if you can cut costs and free up more working capital.

Consider the following ideas:

• monitor regular subscriptions for services such as software to highlight any that are no longer needed by your business
• reduce travel costs by conducting virtual meetings
• outsource services such as accounting, human resources, and marketing instead of employing full-time staff.

Read more about reducing costs.

Negotiate better terms with suppliers

Renegotiating with suppliers could help you improve your working capital.

You could regularly review your supplier contracts to see if you can get a better deal elsewhere.

Alternatively, you might be able to get free or reduced delivery for bigger or more regular orders, as well as discounts for early payments.

To avoid harming your credit standing and reducing your chances of future financial success, it can pay to stick to your suppliers’ terms and conditions.

Cash flow forecasting

Cash flow forecasting predicts future cash inflows and outflows to ensure enough working capital to cover obligations.

By regularly updating and reviewing your forecasts, you could identify potential cash shortfalls ahead of time and take corrective action.

This might include adjusting expenses or seeking additional financing.

This proactive approach could help you anticipate and manage periods of cash shortages or surpluses, keeping your start-up financially stable.

Have a proactive invoice strategy

Promptly sending invoices and following up on late payments can help maintain a steady cash flow and boost working capital.

Consider implementing systems to automate invoicing and set reminders for overdue payments.

This can help to streamline the process and reduce the likelihood of delays.

Read our guide on how to create customer invoices for your start-up.

Prepay certain expenses

Prepaying certain expenses, like insurance or rent, can help you manage cash flow by spreading costs more evenly over time.

By paying in advance, you could also take advantage of discounts offered by suppliers or service providers, which could lead to cost savings.

This approach could help with budgeting and help to ensure that your start-up’s essential expenses are covered.

It could provide peace of mind and free up working capital for other business needs.

Look for tax opportunities

Exploring tax opportunities could involve identifying and using tax credits, deductions, and incentives to reduce your tax liability.

Staying informed about potentially available tax breaks and consulting with a tax professional could help you optimise your tax strategy.

By reducing the amount of tax you owe, you could keep more cash within the business.

This could help you increase your working capital and provide additional resources to invest in growth or cover unexpected expenses.

Working capital finance

Obtaining external funding could help you manage and improve your working capital.

A common way of doing this could be to secure a working capital loan.

This is a type of financing designed to help businesses cover their short-term operational expenses.

This might include costs such as payroll, inventory purchases and other day-to-day expenses that keep the business running smoothly.

A working capital loan is normally short or medium-term in nature.

However, it typically requires assets as security.

Other funding options include:

• overdraft – a line of credit that allows for the withdrawal of more funds that a business has available in its account
• invoice finance – also known as invoice discounting and factoring. This type of funding allows a business to use its invoices and accounts receivable as security for funding
• asset-based lending – this is where a business uses assets it already owns, such as property and machinery, as security against finance.

Before considering any type of external financing, seek independent financial advice to find the funding option that’s best suited to your business.