Q&A - What is “working capital”?

By adding together the totals for current assets and current liabilities in the balance sheet, a very important figure can be calculated – working capital. Working capital provides a strong indication of a business’ ability to pay is debts, and is calculated as: current assets less current liabilities

Every business needs to be able to maintain day-to-day cash flow. It needs enough to pay staff wages when they fall due, and to pay suppliers when invoice payment terms are reached. Maintaining adequate working capital is important both in the short-term (day-to-day) and the long-term. The challenge is to maintain sufficient liquidity in the business to ensure the business can survive and grow in the long-term.

The current liabilities show the amounts that need to be paid in the next twelve months. Current assets show the cash and other assets that are available to settle those current liabilities.

Of course the balance sheet is just a snapshot of the working capital position at a point in time (the balance sheet date). In reality, a business is constantly settling liabilities, taking money from customers, buying inventories and so on. This is known as the working capital cycle, (sometimes also known as the operating cycle) as illustrated below:

In the diagram above:

• The business uses cash to acquire inventories (stocks)
• The stocks are put to work and goods and services produced. These are then sold to customers
• Some customers pay in cash but others buy on credit. Eventually they pay and these funds are used to settle any liabilities of the business (e.g. pay suppliers)
• And so the working cycle repeats

The working capital cycle can often be expressed as a period of time – 60 days, say.

An increase in the length of the cycle (e.g. from 60 days to 65 days) suggests that it takes longer to turn stocks and debtors into cash, or that the payment period for settling creditors has shortened.

Hopefully, each time through the cash flow cycle, a little more money is put back into the business than flows out. But not necessarily, and if management don’t carefully monitor cash flow and take corrective action when necessary, a business may find itself sinking into trouble. The cash needed to make the cycle above work effectively is working capital.

What is crucially important is that a business actively manages working capital. It is the timing of cash flows which can be vital to the success, or otherwise, of the business. Just because a business is making a profit does not necessarily mean that there is cash coming into and out of the business.