Working capital gives companies a quick assessment of how liquid and solvent they are. The figure is relevant for investments and financing – not only for established companies but also for startups.
Solvency, liquidity, cash flow, profitability: for companies, these are essential metrics helping them to check their financial health. It is the basis on which they drive growth and make investment decisions. An important indicator of this is working capital and the working capital ratio.
In this article, you'll learn:
- What working capital is
- How to calculate working capital
- What the working capital formula is
- How companies can use their working capital to make financing decisions
Definition: what is working capital?
Working capital is the difference between a company’s current assets (cash, receivables, inventory) and its current liabilities (payables, debt). It shows how much liquidity a business has for day-to-day operations – a snapshot of short-term financial health. Found on the balance sheet, it’s also called net current assets.
Understand working capital
Working capital is a key indicator of a company’s short-term liquidity and solvency. It shows how well a company can meet immediate debts using its most liquid assets. Positive working capital means the company can invest in growth. Negative working capital signals trouble: the business may struggle with growth, repaying creditors, or even staying afloat. But it’s more than that. Working capital can also serve as a financing tool.
How much working capital a company needs depends on its industry, company size, and risk. Sectors with long production cycles need more working capital due to slow inventory turnover. In contrast, large retailers, with fast-moving sales, often need less.
Working capital formula and calculation of working capital
The formula for calculating working capital is: Current Assets – Current Liabilities.
It describes which parts of current assets can generate short-term revenue and are not debt-financed. Generally, these are inventories and receivables.
Working capital ratio
To calculate their working capital ratio (liquidity ratio), companies must set their current assets in relation to current liabilities.
The formula is: Current Assets / Current Liabilities.
A ratio of more than 1 indicates that current assets exceed current liabilities. Usually, companies want to achieve that.
Current assets include:
- Inventories, like raw materials, supplies, auxiliary materials, finished and unfinished goods, and merchandise.
- Accounts receivables that are converted into revenue within 12 months or one balance sheet year.
- Securities
- Cash and cash equivalents from bank balances and open checks.
Current liabilities include:
- Short-term loans from a bank (< 12 months)
- Overdraft facility
In general, current liabilities include all liabilities with a remaining term of one year or less. They must be paid within this period.
Example calculation working capital
- The balance sheet total is €2.2 million.
- The current assets total €800,000.
- The current liabilities amount to €600,00.
The example calculation shows a working capital of €200,000 and a working capital ratio of 1.3 or 130%. Both key figures are calculated as follows:
Working capital
€800,000 Current assets
– €600,000 Current liabilities
= €200,000 Working Capital
Working capital ratio
€800,000 current assets / €600,000 current liabilities = 1.33
The company has positive working capital, which indicates good liquidity.
Quick and easy calculation
Calculating working capital is simple compared to other balance sheet figures. It gives companies a quick initial indication of how financially healthy they are.
However, working capital only sheds light on the short-term financial situation. Long-term liabilities are not taken into account. They need further calculations. These include, for example, calculating the equity and debt ratio or the debt-equity ratio.
Net working capital
Net working capital identifies which part of a company's assets is part of short-term revenue generation and is not financed by debt.
The formula for calculating net working capital is current assets – current liabilities – cash and cash equivalents.
The importance of working capital for companies
Operational efficiency
Efficient working capital management ensures that a company has sufficient cash flow to meet its short-term obligations and operating expenses. It helps in maintaining smooth operations without interruptions, which is crucial for sustaining business activities and avoiding financial distress.
Solvency and creditworthiness
Maintaining an optimal level of working capital is vital for a company's solvency and creditworthiness. Investors often assess a company's working capital to evaluate its financial health and ability to meet short-term obligations. A robust working capital position enhances a company's reputation and can lead to better borrowing terms.
Profitability and growth
Effective working capital management can directly impact a company's profitability and growth. By optimizing the levels of receivables, payables, and inventory, companies can reduce financing costs, enhance cash flow, and reinvest in growth opportunities. It allows businesses to take advantage of favorable market conditions and invest in new projects or expansion plans.
Working capital as a financing instrument
Traditional financing methods, such as long-term loans and equity financing, are often used for significant capital expenditures and long-term investments. However, working capital financing is specifically designed to address short-term liquidity needs. It provides companies with the flexibility to manage day-to-day operations, respond to unexpected expenses, and capitalize on growth opportunities.
Types of working capital financing
There are several types of working capital financing options available to companies, each with its own advantages and considerations:
- Trade credit: it's a financing method where suppliers allow companies to purchase goods or services on credit, deferring payment for a specified period. This effectively acts as an interest-free loan and is widely used in various industries.
- Short-term loans: these are loans with a maturity period of less than one year. They provide quick access to funds for immediate needs and are often used to bridge temporary cash flow gaps.
- Lines of credit: a credit line is a flexible financing arrangement that allows companies to borrow up to a predetermined limit as needed. Interest is only charged on the amount borrowed, making it an attractive option for managing fluctuating working capital requirements.
- Invoice financing: invoice financing (or factoring) involves selling or pledging accounts receivable to a third party (factor) at a discount in exchange for immediate cash. It helps companies unlock the value tied up in receivables and improve cash flow.
- Inventory financing: inventory financing allows companies to use their inventory as collateral to secure a loan. This type of financing is beneficial for businesses with significant inventory investments and helps them access funds without selling assets.
Benefits of working capital financing
Enhanced liquidity
Working capital financing improves liquidity by providing quick access to funds needed for day-to-day operations. This ensures that companies can meet their short-term obligations, pay suppliers on time, and avoid disruptions in business activities.
Flexibility
Unlike long-term loans, working capital financing options offer greater flexibility in terms of borrowing amounts and repayment schedules. Companies can adjust their financing needs based on seasonal variations, business cycles, and unexpected expenses.
Cost efficiency
Many working capital financing options, such as trade credit and lines of credit, are cost-effective compared to long-term debt or equity financing. They often come with lower interest rates and fees, reducing the overall cost of capital.
Improved cash flow
By optimizing the management of receivables, inventory, and payables, working capital financing helps improve cash flow. This enables companies to reinvest in growth opportunities, reduce reliance on external financing, and enhance profitability.
Challenges of working capital financing
Credit risk
Extending credit to customers or relying on trade credit exposes companies to the risk of non-payment or delayed payments. Proper credit assessments and monitoring are essential to mitigate this risk.
Interest rate risk
Short-term loans and lines of credit often come with variable interest rates. Fluctuations in interest rates can increase borrowing costs, impacting profitability. Companies need to manage this risk through interest rate hedging or by negotiating fixed-rate terms.
Inventory risk
Using inventory as collateral for financing carries the risk of inventory obsolescence or value depreciation. Companies must ensure that inventory management practices are robust and that collateral valuations are regularly updated.
Strategies for working capital financing
Forecasting and planning
Accurate forecasting of cash flows, receivables, and payables is crucial for effective working capital management. Companies should use historical data, market trends, and financial modeling to anticipate financing needs and plan accordingly.
Diversifying financing sources
Relying on a single source of working capital financing can be risky. Companies should diversify their financing sources by combining trade credit, short-term loans, lines of credit, and other instruments to ensure a stable and flexible funding base.
Negotiating favorable terms
Negotiating favorable terms with suppliers, lenders, and other stakeholders can significantly impact the cost and availability of working capital financing. Companies should leverage their creditworthiness and market position to secure better terms and conditions.
Implementing technology solutions
Adopting technology solutions such as automated invoicing, electronic payment systems, and inventory management software can streamline working capital processes, reduce administrative costs, and improve efficiency.
The meaning of working capital
Working capital tells us something about how liquid a company is. It provides initial answers to the following questions:
- Can I meet my short-term liabilities from my funds?
- How well prepared is my company for times of economic crisis?
- Can I handle a drop in revenue well or not?
- If my business is subject to seasonal fluctuations, can I compensate for them?
- Am I in a position to finance further growth?
- How well positioned is my company to receive fresh external capital?
- How much capital is tied up in the company?
Consequences of positive working capital
Positive working capital helps a company to service its short-term liabilities from its resources. It can react to short-term costs and drive expansion and growth - either alone or with the help of third-party financing. Depending on the extent, companies can bridge even difficult economic times.
Consequences of negative working capital
If working capital is negative, the company needs external funds (equity or debt capital) to service its short-term liabilities. This can be an initial indicator that there are structural problems. Liquidity problems and payment difficulties may arise in the future.
Working capital that is too high
However, some companies want to avoid having too much working capital. It is because it indicates that too many funds are tied up, and profitability is suffering as a result.
In that case, idle capital cannot be used for investments and growth projects. It does not add value in the long term. A sign of too much working capital is excessive inventories or large amounts in bank accounts.
Working capital assessment depends on the industry
A working capital analysis and its implications must consider the industry and market in which a company operates. If a business is subject to seasonal fluctuations (e.g., construction or gardening and landscaping), it is common for working capital to fluctuate significantly.
Such companies need to prepare appropriate measures: in months when revenues are high, they need to build up enough working capital to finance the months when revenues are low. Why? During these phases, companies still have to pay rent and salaries.
Distinguishing between working capital and liquidity
"Working capital" and "liquidity" should not be used synonymously. Although there is a connection, working capital should rather be seen as a reference point for evaluating a company's potential liquidity. It is not an exact measure.
Components of working capital
Cash and cash equivalents
Cash is the most liquid asset and the primary component of working capital. Cash equivalents are short-term investments that are readily convertible to cash with minimal risk of value change. Managing cash efficiently involves ensuring that there is enough cash to meet immediate needs while investing surplus cash to generate returns.
Accounts receivable
Accounts receivable represent the money owed to the company by its customers for goods or services delivered. Managing receivables involves setting credit policies, monitoring collections, and reducing the time it takes to convert receivables into cash. Effective receivables management minimizes the risk of bad debts and improves cash flow.
Inventory
Inventory management is crucial for maintaining the balance between having sufficient stock to meet customer demand and minimizing holding costs. Techniques such as just-in-time (JIT) inventory and economic order quantity (EOQ) help optimize inventory levels, reduce carrying costs, and prevent stockouts or overstock situations.
Accounts payable
Accounts payable are the amounts a company owes to its suppliers for goods or services purchased on credit. Efficient payables management involves negotiating favorable payment terms, taking advantage of discounts for early payments, and ensuring timely payments to maintain good supplier relationships and credit ratings.
Working capital management
Now we know what working capital is, how it is calculated, and what influences the working capital ratio. But what if a company wants to improve its working capital?
Then working capital management (WCM) can help.
It describes how companies can influence their working capital. WCM relates to securing and optimizing liquidity. It enables companies to cover their short-term costs and liabilities.
Working capital management strengthens financial stability
Companies strengthen their financial stability through active working capital management. It can lead to higher profitability and company valuation.
Efficient WCM also expands the scope for potential investments and provides an initial indication of how extensive these need to be. Startups in particular can use these measures to make themselves more attractive to investors in preparation for financing rounds.
Three factors have a significant influence on working capital: receivables, liabilities, and inventories.
Factors that influence working capital
Receivables
Many outstanding receivables and long payment terms affect working capital. Companies should use working capital management to ensure a smooth collection of receivables to avoid long payment terms. Both affect their liquidity.
If a company has to wait a long time for the payment of its invoices, it provides upfront payments. This puts a strain on its cash flow as the funds are tied up elsewhere. This restricts the financial scope for action. One solution to this can be working capital financing using factoring.
A company should consider the following points when dealing with receivables:
- Short payment terms I: The longer the customer's payment terms, the higher the level of receivables and the greater the risk of default on a receivable.
- Short payment terms II: If you receive your money quickly, you directly improve your cash flow.
- Comprehensive assessment of creditworthiness: To keep payment defaults to a minimum, customers should undergo detailed due diligence.
- Efficient collection system: This helps to reduce the amount of losses on receivables.
Days Sales Outstanding (DSO)
One key figure to receivables is Days Sales Outstanding (DSO). It measures how long a company needs to collect receivables from outstanding invoices. A high DSO can state problems in receivables management. It offer a starting point for improvements.
Liabilities
As current liabilities directly impact working capital, companies should aim to keep them as low as possible. It can also be an expression of high margins and profits.
However, companies should not just start converting short-term liabilities into long-term liabilities. This is because long-term interest obligations affect a company's liquidity – especially in an environment of rising interest rates.
To improve working capital management, discounts or other reductions positively influence liabilities.
Days Payable Outstanding (DPO)
When it comes to liabilities, companies can use Days Payable Outstanding (DPO). It indicates how long it takes a company to pay third parties. A high value indicates a delay in payments.
A quick repayment leads to a better cash flow. If a company is too pushy in collecting its payable outstanding, it can lead to difficult relationships with suppliers or service providers. This can be a disadvantage in negotiations.
Inventories
For traditional retail companies, e-commerce, or manufacturing companies, inventory management is a way of improving their working capital.
Excessive inventory levels tie up a lot of capital. Stock levels that are too low can lead to delivery bottlenecks and delays.
Companies want to avoid both scenarios. It is important to build up and manage an inventory that is stable in value and able to meet ongoing customer demand. The evaluation of the annual inventory is an indicator of an efficient warehouse management.
Days Inventory Outstanding (DIO)
One key figure for this is Days Inventory Outstanding (DIO). It describes how many days it takes on average for warehouse goods to be sold. It shows how efficiently a company can convert its stock into sales – depending on the sales cycle.
Conclusion: working capital for companies
Working capital is not just a measure of a company's short-term financial health but also a powerful financing instrument that can drive business growth and sustainability.
With working capital financing, companies receive short-term fresh liquidity to settle liabilities, make investments, or improve their cash flow. This is particularly interesting for fast-growing companies.
When financing working capital, companies can access a variety of instruments. Usually, those are tied to debt capital. Depending on the industry and business model, companies can consider the following forms:
- Utilization of the credit line
- Loans on receivables
- Factoring
- Lending on inventories
- Alternative financing models, such as revenue-based financing or recurring revenue financing
Companies have increasingly turned their attention to working capital in recent years. They have also found new ways of debt financing as a result.
