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Accounting

What is Working Capital?

Working capital is current assets minus current liabilities. It's the money available for day-to-day operations.

Example

Current assets £50k - Current liabilities £30k = Working capital £20k.

Key Dates

Monitor regularly to ensure you can pay bills

How Working Capital Works in Practice

Working capital is the difference between your company's current assets and current liabilities. It measures the short-term financial health of your business -- whether you have enough liquid resources to cover your obligations over the next 12 months. Positive working capital means your current assets exceed your current liabilities. Negative working capital means you may struggle to pay your bills.

Current assets are things that can be converted to cash within 12 months: bank balances, accounts receivable (money customers owe you), stock or inventory, and prepayments. Current liabilities are obligations due within 12 months: accounts payable (money you owe suppliers), PAYE and NI owed to HMRC, VAT owed, Corporation Tax due within the year, short-term loan repayments, and accrued expenses.

The working capital cycle (also called the cash conversion cycle) describes how quickly your business turns raw materials or services into cash. It has three components: how long you hold stock, how long customers take to pay you, and how long you take to pay suppliers. A shorter cycle means cash comes in faster. For service businesses with no stock, the cycle is primarily about how quickly customers pay versus how quickly you pay your own costs.

Working capital requirements tend to increase as your business grows. If revenue rises by 30%, you will likely need more stock, more outstanding invoices, and more supplier credit. This working capital increase must be funded from somewhere -- retained profits, additional capital, or borrowing. Many growing businesses fail not because they are unprofitable but because they cannot fund the working capital needed to support their growth.

Step by Step

Working capital is calculated directly from your balance sheet: Current Assets minus Current Liabilities. The working capital ratio (current assets divided by current liabilities) gives you a quick health check. A ratio above 1.0 means positive working capital; below 1.0 means negative. Most lenders and advisors look for a ratio between 1.2 and 2.0 for a healthy small business.

To manage working capital actively, you need to optimise each component. Speed up cash collection by invoicing promptly, enforcing payment terms, and offering early payment incentives. Reduce stock levels to the minimum needed to fulfil orders. Negotiate favourable payment terms with suppliers. Each improvement frees up cash that was previously tied up in the working capital cycle.

A working capital forecast projects your future working capital needs based on expected sales growth, payment patterns, and seasonal fluctuations. Seasonal businesses may have very different working capital needs at different times of year. Retailers need extra working capital before Christmas to stock up. Construction companies may need working capital to fund projects before milestone payments arrive.

Practical Tips

  • Calculate your working capital monthly using your balance sheet and track the trend -- a declining trend needs attention even if the absolute number is still positive
  • Reduce your working capital cycle by shortening customer payment terms and lengthening supplier payment terms where possible
  • If your business is seasonal, forecast working capital needs at least 3 months ahead so you can arrange financing in advance rather than in a crisis
  • Consider an invoice finance facility or business overdraft as a standby working capital buffer -- arrange it when you do not need it, because banks are less helpful when you are already in trouble

Common Mistakes to Avoid

  • Ignoring working capital until a crisis -- by the time you cannot pay a supplier, the problem has been building for months
  • Not recognising that business growth requires additional working capital, leading to cash crunches during expansion
  • Letting accounts receivable grow unchecked while paying suppliers promptly, creating an avoidable working capital squeeze
  • Confusing working capital with profit -- a profitable business can have negative working capital if cash is tied up in slow-paying customers or excess stock

Frequently Asked Questions

What is a good working capital ratio?

A ratio between 1.2 and 2.0 is generally considered healthy for a small UK business. Below 1.0 means current liabilities exceed current assets, which is a warning sign. Above 2.0 may suggest you have too much cash sitting idle that could be invested in the business.

Can a profitable company have negative working capital?

Yes. If your profits are tied up in accounts receivable (unpaid invoices), stock, or have been spent on fixed assets, you can be profitable but have negative working capital. This is a common situation for growing businesses and can be addressed through credit control, stock management, or financing.

How do I fund a working capital shortfall?

Options include: improving collections from customers, negotiating longer supplier terms, reducing stock levels, securing an overdraft facility, invoice factoring (selling your receivables for immediate cash), or injecting personal funds as a director's loan. The best approach depends on the cause of the shortfall.

How often should I check my working capital?

Monthly at minimum. Run a balance sheet each month and calculate working capital. Also monitor debtor days and creditor days trends. For businesses with tight cash flow, weekly cash flow monitoring effectively serves as a working capital check.

Does working capital include director's loan accounts?

If the director's loan account is a current asset (the director owes the company money repayable within 12 months), it is included in current assets and therefore in working capital. If the company owes the director money, it is a current liability. Be cautious about relying on a director's loan as working capital if there is no clear repayment plan.

Source: HMRC Business Income Manual: https://www.gov.uk/hmrc-internal-manuals/business-income-manual

Related Terms

Cash Flow

Cash flow is the movement of money in and out of your business. Positive cash flow means more money coming in than going out.

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