What is working capital?
Working capital is quite simply the amount of money a business uses to fund its operating cycle. That includes the cash needed to source products from suppliers, then hold that stock, before finally selling the goods to consumers as the cycle repeats.
There are many factors that can influence exactly how much working capital a business needs. These include:
- The nature of the product. How long does it take to manufacture? Can it be stored cheaply?
- The terms offered by a supplier. Do they offer credit options? Can they quickly scale production to match unexpected demand?
- The financing options you’re able to offer your customers. Are you making credit options readily available? How does this affect the holding period of your stock?
In an ideal world, every business would be able to operate with fairly low levels of working capital; minimizing the amount of time and resources spent on holding stock while maximising cash reserves and delivering goods quickly to the consumer.
Practically speaking, though, this isn’t always an option - and so in this article we’ll share some tips to help you navigate working capital challenges.
The working capital formula
Understanding how to calculate working capital is a good first step for businesses looking to make financial and practical efficiencies in their operating cycle.
There’s a simple formula to follow:
Working Capital = Current Assets – Current Liabilities
So, for example, let’s imagine that your local restaurant has £50,000 worth of assets, which include equipment, total amount of cash in the bank, and inventory (either stock or raw materials on-site).
If they also have liabilities totalling £30,000, which include the debts they owe to suppliers, or any money they’re due to receive if, say, they’ve allowed a large party to book in advance – then they have a working capital of £20,000.
The complexity of this equation can increase depending on the different types of assets and liabilities owned by the business, while the basic premise remains the same.
Why is working capital important?
There’s an obvious link between cash flow and working capital, and the decisions you make around how you manage working capital will directly impact the amount of cash you have access to.
If, for example, you’re able to negotiate with your suppliers to secure more flexible payment terms for your business, and a quicker turnaround of them producing and delivering goods to your premises, then you’ll find yourself holding less stock – and having more cash in your account each month.
Broadly speaking, truly understanding your working capital patterns, and factoring this information into a well thought-out cash flow forecast could help improve your financial management. What’s also useful is to understand the jargon around the topic, so let’s take a look at some relevant terms.
1. Net working capital
This is the common term for representing the working capital figure using the formula we’ve already outlined. Your annual balance sheet will have all the information needed to make this calculation, and it’s useful both to your business (which needs to cover its short-term expenses), and any external parties who are looking to invest in or lend money to your company.
2. Negative working capital
‘Negative’ here refers to below zero, rather than ‘bad’ per se. When a business has negative working capital, its current liabilities exceed its assets. This may at first seem undesirable, but it can in fact be a good position for your business to be in.
If you’re generating sales rapidly and offering credit to your customers - then you may find yourself selling products before you’re able to actually pay your supplier costs. Consequently, in this instance you’re using your supplier’s money to grow your business, and the suppliers themselves may be happy with this arrangement given they’re increasing their accounts receivable.
Negative working capital models are popular in some industries, but not all - and they may require a careful credit control process to guarantee customers can pay in full.
3. Working capital ratio
This ratio helps gauge a business’ ability to pay its suppliers. This could, for example, be useful to investors or external finance providers.
To calculate your working capital ratio, divide your total assets by your total liabilities using the best data available to you. Ratios of around 2:1 are considered comfortable by most businesses.
Working capital finance
With all of this in mind and a clear picture of your working capital needs, you can start planning for the future. If you’re struggling to maintain the levels of working capital your business needs to succeed, though, you may want to consider seeking financial support.
One popular option for doing this is seeking out a business loan, which could offer you large volumes of lending with fixed repayment terms. However, if you’re finding yourself in need of more short-term finance to help your business seize growth opportunities, you may benefit from our product at NatWest Rapid Cash.
We’ve developed an innovative method of invoice financing, in which our software integrates with your accounting package to offer you cash up-front while you’re waiting for invoices to be paid. Our product has competitive rates, and you can learn more about it on our home page.
To be eligible for Rapid Cash you must be trading for more than 6 months, have an annual turnover of at least £100k and either be a Limited Company or Limited Liability Partnership in England and Wales. Additionally, you need to invoice other businesses and use one of the following digital accounting software: Xero, Quickbooks, Sage 50, Kashflow, FreeAgent and Netsuite.
Security and guarantee required. Product fees may apply.