As a business owner, you know you won’t get very far without money. You need it to purchase inventory, pay your bills, take care of payroll, upgrade your equipment, expand into new markets, and more. In other words, having enough money when you need it is one of the primary ways to maintain the financial health—and overall success—of your company. The leftover money when you subtract your expenses from your revenue is called working capital. According to the 2019 Voices of Small Business in America report, an estimated 29% of businesses that received new funding that year bought new equipment, 27% hired new employees, 18% increased their market spend, and 17% bought or leased new land or new buildings. In other words, working capital and funding to supplement working capital when needed are paramount to business growth, expansion, and development.
In this ultimate guide to working capital, we’ll dive into what working capital is, how to calculate and monitor it, and what options are available to companies that find themselves in need of additional working capital.
What Is Working Capital and Its Importance?
Put simply, working capital is the amount of money your business has available after subtracting your expenses from the money your company is bringing in. Using financial terms, it’s defined as the difference between a company’s current assets and its current liabilities. For example, if a company held $750,000 in assets and $400,000 in liabilities, their working capital would be $350,000 and their working capital ratio would be 1.875. More on how we came to these numbers later!
Working capital is different from revenue and profit, and tracking all three can help you understand your business’ financial-well being. While revenue looks only at money coming in, working capital takes into account things like interest or principal payments on business loans, investments, and accounts payable and receivable. In other words, it measures your short-term financial solvency and health. This differentiation is important; a company can have profits, but with too many investments or too long of a window for your customers to pay bills or invoices, you might not have the cash on hand when you need.
And therein truly lies the importance of working capital: even if you’re turning a profit, you can’t get by without liquid cash and assets to take care of all your bills and liabilities.
What Are the Types of Working Capital?
To complicate matters, working capital isn’t always referring to the same pool of money. It can be classified into several different categories and subcategories that allow businesses to keep better track of their current working capital and liquidity. The primary four types of working capital are net, gross, permanent, and variable.
Net Working Capital
What most people are referring to when they talk about working capital is net working capital. Net working capital is the total amount of assets that exceed current liabilities. It can be high or low, but businesses that find their net working capital in the negative may need to develop a plan to get back into the positive.
Gross Working Capital
Gross working capital refers to the total amount of cash and assets in the business at any given point in time. A gross working capital example might include cash, accounts receivable, inventory of raw or finished goods, or short-term investments. Gross working capital isn’t necessarily telling of a company’s financial well-being; it is best used when compared to current liabilities. It is important to note that gross working capital assets should be able to be converted to cash relatively quickly. As such, long-term investments aren’t generally considered in this category.
Permanent Working Capital
What is permanent working capital? Sometimes referred to as “fixed working capital,” it’s a measure of the minimum amount of cash or current assets that must be held on hand to cover current liabilities. In other words, it’s your assets that are tied up. The amount of permanent working capital a company will need depends on its size and growth. The larger the company and the quicker it grows, the more permanent working capital will be needed. Permanent working capital is divided into two subcategories: regular and reserve.
Regular Working Capital: Regular working capital is a measurement of the least amount of capital that is needed to cover expected work expenses under normal conditions. Regular working capital covers expenses like salary and payroll, overhead costs, and costs for any needed materials or supplies.
Reserve Margin Working Capital: Your reserve margin working capital acts like a safety net or a rainy day fund. It’s a measure of the capital set aside to cover any and all unforeseen circumstances like natural disasters, inflation, repair costs, layoffs, and more. If the past few years have taught us anything it’s that we can’t predict the future, but reserve working capital lets you prepare for the unexpected.
Variable Working Capital
Otherwise known as flux or temporary working capital, this type of working capital refers to the amount of cash and assets needed to meet temporary or seasonal needs. While some expenses need to be accounted for monthly (like payroll and bills), variable working capital looks specifically at the seasonal or temporary need for liquidity. Variable working capital is divided into two subcategories: seasonal and special.
Seasonal Variable Working Capital: For businesses with peak seasons, keeping seasonal variable working capital in mind is absolutely critical. This type of capital defines the amount of cash and assets needed to operate effectively and efficiently during a particularly busy season.
Special Variable Working Capital: This type of capital accounts for unexpected operational or business expenses a company may need to make on a short term, irregular basis. For example, you could use it to cover costs associated with the upgrading of equipment to improve operational efficiency, product development, and more.
How Do You Calculate Working Capital?
Fortunately, with the right information, calculating working capital is fairly straightforward. Once you have your current assets and liabilities worked out, it’s simple subtraction. Just subtract your current liabilities from your current assets. Laid out as a formula, it looks like this:
Current assets - Current liabilities = working capital
You may also be interested in calculating your company’s working capital ratio. This is an easy calculation as well. Just divide your current assets by your current liabilities.
Current assets / current liabilities = working capital ratio.
But what are some examples of working capital? In other words, what do you need to look at when adding up your assets and liabilities? While most people look at on-hand inventory, accounts payable, accounts receivable, and cash, the truth is there’s a lot more to it than that. Here is a starting point for calculating both.
When calculating working capital, current assets are any assets or dollars on hand that can be converted into cash within roughly 12 months (or a normal year’s operating cycle for your company). Below is a list of common current assets.
Cash and cash equivalents that aren’t already accounted for
Inventory, including raw materials, components, and finished goods (When considering inventory in your current assets, keep in mind that you may not move all of your on-hand products within a fiscal year)
Money coming in from accounts receivable that will be paid during the next year (Companies that offer long-term credits or invoicing may need to carefully calculate this figure)
Marketable securities, like an interest-bearing Treasury bill or bond
Prepaid expenses, or payments that have been made in advance for any goods or services that will be used in the future
Any other liquid assets Much of this information should be available on your company’s balance sheet—which is just one reason why solid bookkeeping and accounting is so important. To calculate your current assets, simply add up each of these dollar amounts.
Current liabilities, on the other hand, are your short-term financial obligations. Typically, current liabilities are measured as those financial obligations that will need to be paid during the next 12 months or your normal operating cycle. Below is a list of common liabilities companies should consider when calculating working capital. Like the assets above, many of these numbers should be available on your balance sheet.
Accounts payable, including anything that needs to be paid over the next year
Short-term debts, including dividends, outstanding principal, or interest payments
Current deferred revenue, including work or products prepaid by customers
The maturity of any long-term debts over the next 12 months
Income taxes that will be paid over the next year
Any other current liabilities that apply to the next year
How Do You Interpret Your Working Capital?
The math for working capital is fairly straightforward. But what do the numbers actually mean? How much working capital is enough? Is there ever a time when you have too much working capital?
Broadly speaking, a positive amount of working capital indicates you have money on hand to take care of your liabilities—and then some. A low—or even negative—amount of working capital, on the other hand, may be a sign that a company is struggling financially. To dive further into the ins and outs of working capital, we’ve compiled a list of frequently asked questions to help you determine the right amount of working capital for your company.
What Is a Good Working Capital Ratio?
Generally speaking, advisors tend to agree that if your working capital ratio is somewhere between 1.5 to 2.0, you’re operating with a healthy amount of working capital.
With that said, the optimal working capital ratio does vary from industry to industry. Retail businesses and manufacturers, for example, often have higher ratios of working capital to support their inventory load—especially during peak or holiday seasons when business is booming.
Software and tech companies that sell software products and services—not physical products—tend to operate with a lower working capital ratio, especially when they’re operating with a small team. Their products are intangible and there often isn’t a need for physical inventory at all.
Is High Working Capital Ratio Good?
The more working capital you have on hand the better, right? The truth is more nuanced. Of course, spinning revenue into working capital is excellent, and having working capital stashed away in a rainy day fund is great, too. However, there are instances where having a high working capital ratio isn’t ideal.
If expanding your business is your goal and your ratio is consistently above 2.0, it may be a sign that you’re not using your assets to their full potential. Remember, you’ve got to spend money to make money, especially if you’re in a growth phase.
Is Low Working Capital Good?
Yes and no—it all depends on the situation. As we discussed above, a ratio of at least 1.5 is ideal. Any ratio that is rapidly approaching 1.0 or lower (a ratio of 1.0 indicates the same level of assets and liabilities) may indicate cash flow struggles or financial instability. But there are times when a low working capital ratio doesn’t scream disaster.
For example, it may be necessary to purchase new equipment, hire new employees to assist with expansion, or purchase products ahead of peak season. In these instances, your working capital ratio may dip closer to 1.0. Of course, companies that operate with little to no physical inventory can get away with a relatively low working capital ratio. And this can be beneficial, especially if more revenue can be used for investments and operational efficiencies.
If you find that you’re in need of additional working capital—especially to support growth projects— there are options like loans or business lending services that can support your immediate financial needs. Our company, Backd, specializes in providing small businesses with short-term working capital solutions… but more on us later!
What Factors Go into Determining What My Working Capital Should Be?
In the above sections, we mentioned some of the factors that go into ideal working capital ratios, like inventory and peak seasons. But what are the other factors to consider?
Industry: Retail, manufacturing, and construction industries often need higher working capital ratios. Consider that they need to purchase inventory—often upfront—to use or sell, and they have to account for fluctuations in wholesale pricing, too. To think through a working capital example, let’s look at construction. Throughout 2021 and 2022, lumber prices have seen steep increases, and they need higher amounts of working capital to purchase the products they need to complete a project.
Company Size: Smaller, scrappy companies can usually get away with less working capital. There are fewer people to pay and often there are fewer assets, too. Enterprise-level companies need higher levels of working capital to grow and maintain large-scale operations.
Seasonal Changes: For companies that have peak seasons, there’s a lot of planning involved. That includes pre-purchasing products or raw materials to be able to meet increased demand. To do so, they’ll need more working capital than usual. This may cause a temporary dip in their working capital ratio.
Operational Efficiency. No two companies operate exactly the same way. Some companies have short sales cycles while others have longer cycles. Some companies require customers to pay upfront, others charge at the time of receipt, and others still offer payment plans or a 30- or 60-day payment window. All of that impacts how much working capital a business needs to maintain business as usual.
How Do I Manage My Working Capital?
In order to monitor their working capital, companies use a financial strategy called working capital management. In essence, working capital management involves a combination of inventory management and accounts management to capture a holistic view of current assets and liabilities. With working capital management, companies can maintain their business cycle, ensure continued operational efficiency, and optimize how and when they spend their working capital to increase profitability.
In addition to the equations described above, working capital management experts use the collection ratio and the inventory turnover ratio.
Also called the days sales outstanding, the collection ratio provides an average estimate of the number of days it takes a company to receive payment after a credit sale (Cash sales are not accounted for in this as payment is received immediately). To calculate the collection ratio, first, divide the number of outstanding accounts receivable by the total amount of credit sales during the same period. Then, multiply that by the number of days in the period. Laid out mathematically, that formula looks like this:
(Total accounts receivable/total credit sales) X number of days = collection ratio.
The higher the ratio, the longer it’s taking a business to collect payment. This may result in cash flow issues or a lack of working capital.
Inventory Turnover Ratio
For companies that operate with physical inventory that must be bought and sold, having an understanding of how quickly that inventory leaves your facility is important. Not only can you understand how much to purchase and when you need to restock, but you can also avoid unnecessary amounts of inventory.
To calculate the inventory turnover ratio, divide the cost of the goods sold during a set amount of time by the average quantity of inventory. That looks like this:
Cost of goods sold / average inventory = inventory turnover ratio
Companies need to find a balance with their inventory turnover ratio. While a high ratio means you likely won’t have storage and holding costs, a ratio that’s too high may mean you don’t have enough in stock to meet demand. On the flip side, a low ratio may mean you’re carrying too much inventory.
What If You Have a Need for Additional Working Capital?
If you’ve made it this far, it’s probably clear that it’s not uncommon for companies to need an influx of working capital. You might find yourself needing some extra capital to get ready for your busy season. You might need immediate working capital to pay vendors or suppliers while you wait for your accounts receivable to come in. You might need working capital to purchase new equipment or hire new employees to keep up with an increase in demand.
Ultimately, it doesn’t matter as much why you need it—you just know you need it. In these instances, there are a couple of main options that businesses can turn to, including loans and alternative business financing.
There are a number of loan options available to business owners, including term loans, small business loans, lines of credit, equipment loans, invoice factoring, invoice financing, merchant cash advances, personal loans, business credit cards, and microloans. Most loans have repayment plans that range from three years up to 10 years.
To qualify for a loan, you typically need to meet four basic requirements: a high credit score, detailed information on cash flow and annual revenue, an updated business plan that lays out your company’s stability, and additional collateral (like equipment or assets). The process of applying for and receiving a loan varies quite a lot, and it can take days, weeks, or even months to get the cash in your pocket.
Alternative Business Financing
In certain situations, loans can be a great option for businesses. But for companies that need working capital fast and want to be able to pay it off quickly too, there’s another option. At Backd we provide short-term financial solutions to get working capital into your pocket fast. Our merchant advances offer amounts between $10k and $2M with term lengths from 4 to 14 months.
If you’ve been in business for at least one year, have a personal credit score of at least 600, have a minimum annual revenue of at least $300k, and have at least 10 months of deposits in a business bank account, Backd might be the right option for you.
Backd: Empowering Small Businesses with Working Capital
At Backd, we believe in small businesses and the vital role they play in our economy. Our goal is to make business financing as quick and easy as possible. We offer competitive rates, same-day decisions, a speedy application process, and flexible terms.
Our customers are unique, and their working capital solutions should be too. This year alone, we’ve provided merchant advances to companies in areas like cannabis, building and construction, water delivery, and more. More than 3,700 businesses are currently being Backd. Interested in becoming one of them? Fill out our secure application or reach out to us today. We’d love to talk about how we can help you grow.