What is working capital? A plain-English guide for business owners

Ask ten owners what working capital is and you will get ten answers. The accounting definition is simple: current assets minus current liabilities. The practical definition matters more. Working capital is the cash you can reach in the next few months to pay the bills that are due in the next few months.

It is also one of the first things a lender, a bank or a buyer looks at, because it shows whether a business can absorb a slow month, a late customer or a big order without a crisis.

The formula

Current assets are cash, accounts receivable and inventory: things that turn into cash within a year. Current liabilities are accounts payable, accrued payroll and taxes, credit card balances, and the next 12 months of payments on longer-term debt. Subtract the second from the first.

• Positive working capital: you can cover near-term obligations from near-term money.
• Negative working capital: you are relying on new sales or new borrowing to pay what is already due.
• Current ratio: current assets divided by current liabilities. Lenders often look for a ratio comfortably above 1, though the right number depends on the industry.
• Quick ratio: the same calculation without inventory, for businesses whose stock is slow to sell.

A simple example

A landscaping company has $40,000 in the bank, $65,000 in unpaid invoices and $15,000 in materials on hand: $120,000 in current assets. It owes suppliers $30,000, owes $20,000 in payroll and payroll taxes, and has $35,000 of equipment payments due over the next year: $85,000 in current liabilities. Its working capital is $35,000 and its current ratio is about 1.4. Healthy on paper, but if those invoices arrive 60 days late, the bank balance alone won’t cover payroll.

Why profitable businesses still run short

Profit and cash are different. A contractor can book a profitable job in March and not see the money until June, while paying crews and suppliers every week in between. A distributor can grow sales 30% and run out of cash because every new order ties up more inventory and more receivables.

This is the cash conversion cycle: the days it takes to turn a dollar spent on materials and labor back into a dollar collected. It is calculated as days of inventory plus days of receivables, minus days of payables. The longer the cycle, and the faster you grow, the more working capital you need.

Ways to improve it without borrowing

• Invoice the day the work is done, and follow up on anything past due within a week.
• Offer a small discount for early payment, or ask for deposits on large jobs.
• Negotiate longer terms with suppliers, especially on large orders.
• Trim slow-moving inventory and stop reordering items that don’t turn.
• Finance long-lived equipment instead of paying cash, so operating cash stays for operating costs.

When financing makes sense

Borrowing for working capital makes sense when the need is tied to something that will produce cash: a new contract, a seasonal inventory build, or the ramp-up period after you add a machine. It makes less sense when it covers losses that will repeat next month, because the payment adds to the problem it was meant to solve.

Match the financing to the need. Long-lived equipment belongs on a multi-year equipment loan or lease. A short-term need belongs on a short-term working capital loan or a line of credit. Paying for a 10-year machine out of a 12-month working capital loan, or the other way round, strains cash flow for no reason.

How lenders size working capital

Lenders size working capital to cash flow. They read recent bank statements to see average deposits and balances, check existing debt payments, and look at how the money will be used. A request backed by a signed contract or a purchase order is easier to approve than a general one. If you are also buying equipment, the equipment can support the request.

The bottom line

Know your number, watch your cash conversion cycle, and keep equipment purchases from eating the cash you need to run the business. If you are buying equipment and need working capital too, see how LenderCloud pairs the two on our working capital page. All financing is subject to credit approval.