Cheat sheet: Working capital, and getting your ratio right

Working capital is vital for every business — quite simply, if you don’t have enough, it can be a problem, regardless of how profitable you’re going to be in the future. 

Here’s what you need to know, plus some working capital solutions to help you bridge any gaps. 

What is working capital? 

Working capital is the cash — or cash equivalent — your business has available at any given time, minus the money you owe this year. 

How do I work out my working capital? 

Working capital is calculated by subtracting your current liabilities from your current assets. So, for example, if you have $24,000 of current assets and $18,000 of current liabilities, your working capital would be $6000. 

What type of things are classed as current assets? 

Current assets can include cash, any invoices you have issued, expenses you’ve prepaid and, of course, inventory. 

What type of things are classed as liabilities? 

Liabilities are anything you owe, including invoices you’ve not paid, payroll, any goods or services you’ve been prepaid for but haven’t delivered, anything you owe to the Australian Tax Office (ATO), and any short-term loans or debts, plus any portion of long-term debt repayable over next 12 months. 

Why is working capital important? 

Working capital is a great indicator of the health of your business — and that’s useful for you and potential investors. Companies that end up going out of business usually do so because they can’t meet current obligations rather than being unprofitable. 

What’s a good and bad working capital ratio? 

It depends on your business, but generally, a ratio of 1 — i.e. you have double the money you owe — is adequate. Below 1 indicates things are tight, while under zero means you can’t repay the money you owe. Good working capital is usually benchmarked between 1.2 and 2. 

Can your working capital be too high? 

In some respects, yes. If your working capital is high, it may be a sign you’re not reinvesting in the business effectively and missing out on opportunities to grow. 

Is working capital the same as cashflow? 

They’re similar, but not the same. Working capital gives a snapshot of the moment, whereas cashflow is an indication of the money the business can bring in over a specific period. If your working capital is too low, your business could find itself encountering difficulties. A good example of the difference is if you purchased, for example, $30,000 of stock — your cashflow would decrease as you’d spent that money. However, your working capital would remain the same as you still have that value of the asset (inventory). 

Can working capital be low and cashflow be strong? 

While most businesses with a high cashflow will also have high working capital, that’s not always the case. Your working capital could be low, but your projected future sales are strong. This may cause short-term issues when it comes to paying bills and wages, but in the longer term, the business looks healthy. 

What can I do to ensure I don’t run out of working capital? 

If you need a working capital boost to meet repayments or invest in the business, there are several ways you could approach it. They include liquidating some longer-term assets (for example, selling and leasing back equipment), attracting investment, extending debt terms or taking out some business finance. 

Working capital cycles and growth

If you pay your suppliers in 30 days, but take 60 days to collect your receivables, your business has a working capital cycle of 30 days.

The longer the cycle is, the longer your business is tying up capital without earning a return on it. If you need a bank operating line, or another form of finance to bridge the 30-day gap, you end up paying interest, or fees, that eat into your profitability.

If you balance your incoming and outgoing payments to minimise net working capital, you can maximise free cashflow. 

Growing businesses require cash, and being able to free up cash by shortening the working capital cycle is one of the most inexpensive ways to grow.