What is working capital and how do you calculate it?

You’ve got a full order book and plenty of sales, but your bank account’s looking a bit thin. Why? The answer usually lies in your working capital. It’s a common frustration for UK business owners: you’re profitable on paper, but you’re constantly “cash-poor” because your money’s tied up in unpaid invoices or unsold stock.

Working capital is the heartbeat of your daily operations. It’s the money you use to buy materials, pay your staff, and keep the lights on while you wait for your customers to settle their bills. Calculating your working capital helps you stay in control of your cash flow, so you’re never caught off guard by unexpected costs or slow-paying customers.

In this article, we’ll explain how to calculate your working capital, what a good ratio looks like, and how you can speed up your cash cycle to fuel growth without needing to borrow.

What is working capital?

The meaning of working capital (also referred to as ‘net working capital’) is the money your business has available to cover everyday expenses, like paying suppliers, employees, and taxes. It’s not a measurement of the cash currently in your bank account – that’s called cash flow. Working capital shows what’s left over after what you owe (your current liabilities) is subtracted from what you own (your current assets) over the next year.

If your assets are greater than your liabilities, you’re in a good position to handle unexpected costs or opportunities. But if you owe more than you own, you could struggle to pay bills on time, leading to cash flow problems or even insolvency.

Working capital also shows how efficiently your business is running. Too little, and you risk running out of cash when you need it. Too much, and you could put unallocated money to better use, like investing in growth or improving operations.

What are current assets?

Current assets are the resources your business can convert into cash within 12 months. They can include:

• Cash in your bank account, undeposited cheques, or petty cash

• Money customers owe you for goods or services already provided

• Stock you plan to sell, like raw materials or finished goods

• Payments you’ve made in advance, such as insurance or rent

• Short-term investments, like stocks or bonds, that can be easily sold for cash

What are current liabilities?

Current liabilities are the bills and debts your business needs to pay within the next 12 months. They can include:

• Money you owe to suppliers for goods or services received

• Salaries, bonuses, or other payments due to employees

• VAT, PAYE, National Insurance, and corporation tax due within 12 months

• Debts that need to be repaid within a year, like overdrafts or credit card balances

• Costs you’ve already incurred but haven’t paid yet, such as utility bills or rent

• Money customers have paid you in advance for goods or services not yet delivered

What is positive vs negative working capital?

Positive working capital means your business has more current assets (like cash, unpaid customer invoices, and stock) than current liabilities (like bills and short-term loans). This is a healthy sign, as it shows you can cover your immediate costs and have extra funds for unexpected expenses or growth.

Negative working capital means you owe more in the short term than you currently have in assets. This can be a warning sign that you might struggle to pay bills on time. But some businesses, like supermarkets or subscription services, deliberately operate this way – they collect cash from customers upfront but take longer to pay suppliers, using that delay as a form of short-term funding.

What is the working capital cycle?

The working capital cycle shows how many days your cash is tied up in your business. It includes how long it takes to sell inventory, collect customer payments, and pay suppliers. This helps you understand your business’s short-term financial health and cash flow efficiency.

You can calculate your working capital cycle using this formula:

Here’s what each part means:

• Days inventory outstanding (DIO) measures how long your stock sits before it’s sold

• Days sales outstanding (DSO) measures how long customers take to pay you after a sale

• Days payables outstanding (DPO) measures how long you take to pay your suppliers

For example, if you sell stock in 60 days, collect payments in 30 days, and pay suppliers in 45 days, your cycle is 45 days. A shorter cycle means better efficiency, while a longer one may signal slow sales or late payments.

For more information, read our guide: “What is a working capital cycle?”.

How to calculate working capital

To calculate your business’s working capital, just subtract what you owe in the short term from the value of any assets you own that can be turned into cash quickly.

So, to calculate working capital, you can use this formula:

• A positive result means you’ve got enough to pay your bills and handle surprises

• A negative result suggests you might struggle to cover costs when they’re due

You can find your current assets and liabilities on your balance sheet (part of your annual accounts). If you use certain accounting software, you should be able to pull this report in seconds.

Working capital calculation examples

Example 1: Cafe

This cafe has:

• £15,000 in cash

• £10,000 owed by customers (unpaid invoices for catering events)

• £5,000 worth of coffee beans, pastries, and other stock

Total current assets = £30,000

They owe:

• £8,000 to suppliers

• £7,000 in wages

• £3,000 on a short-term loan

Total current liabilities = £18,000

Working capital = £30,000 - £18,000 = £12,000

They’ve got £12,000 as a safety net – enough to restock ingredients or cover an unexpected repair, like a broken espresso machine.

Example 2: Online retail store

This e-commerce business has:

• £40,000 in cash

• £25,000 owed by customers (outstanding online orders)

• £10,000 worth of inventory in their warehouse

Total current assets = £75,000

They owe:

• £20,000 to suppliers

• £5,000 in VAT

• £2,000 on a business credit card

Total current liabilities = £27,000

Working capital = £75,000 - £27,000 = £48,000

With £48,000 in working capital, they can invest in new stock for a busy season or upgrade their website to handle more traffic.

Example 3: Freelance graphic designer

This designer has:

• £8,000 in cash

• £6,000 owed by clients (unpaid invoices)

• £1,000 worth of software subscriptions and equipment (prepaid for the year)

Total current assets = £15,000

They owe:

• £2,000 in tax (self-assessment)

• £1,000 on a short-term loan for new equipment

Total current liabilities = £3,000

Working capital = £15,000 - £3,000 = £12,000

Their £12,000 buffer gives them the flexibility to take on bigger projects or cover their living costs while waiting for client payments.

What is a working capital ratio?

The working capital ratio (also called the ‘current ratio’) shows whether your business can pay its short-term bills using the assets it currently has.

Unlike net working capital, which tells you the exact amount of money you have available, the working capital ratio gives you a quick way to compare your liquidity to industry standards or your own past performance.

How to calculate working capital ratio

You can calculate your working capital ratio using this formula:

Working capital ratio examples

Example 1: Healthy retail business

• £740,000 in current assets

• £405,000 in current liabilities

Working capital ratio = 1.83

This business is in a strong position. But they should check if they’re holding too much stock, as excess inventory can tie up cash unnecessarily.

Example 2: Struggling cafe

• £100,000 in current assets

• £120,000 in current liabilities

Working capital ratio = 0.83

A ratio of 0.83 is a cause for concern. This cafe doesn’t have enough assets to cover its liabilities, which could lead to cash flow problems. They might need to look into options like invoice finance or a short-term loan to help bridge the gap.

Example 3: Efficient service business

• £160,000 in current assets

• £110,000 in current liabilities

Working capital ratio = 1.45

With a ratio of 1.45, this business is in good shape. They have enough liquidity to cover their obligations and can focus on growing their client base.

What is a good working capital ratio?

For most UK businesses, a healthy working capital ratio is between 1.2 and 2.0.

• Below 1.0: This is a warning sign. Your liabilities are higher than your assets, which means you might struggle to pay bills on time. It could point to cash flow issues.

• 1.2 to 2.0: You’re in good shape. Your business has enough assets to cover its short-term debts, plus a buffer for unexpected costs.

• Above 2.0: While this might seem great, it could mean you’re not using your assets efficiently. For example, you might be holding onto too much stock or cash that could be reinvested to grow your business.

Different sectors have different ideal ratios due to how they operate and what they sell:

• Retail businesses usually aim for around 1.5, as they need to balance stock levels with customer demand

• Service-based businesses (like consultancies) often operate comfortably with a ratio of 1.0 to 1.3, since they don’t have as much tied up in inventory

How can you improve your working capital?

If your business is struggling with cash flow or has a low working capital ratio, there are several ways to go about improving your working capital.

Get paid faster

• Offer customers a small discount for paying invoices early

• Use invoice financing to immediately unlock cash from unpaid invoices

• Send invoices as soon as the work’s completed and chase overdue invoices promptly

Manage your stock better

• Switch to a just-in-time (JIT) system so you only order stock when you need it

• Clear out old or slow-selling stock with discounts to free up cash

• Negotiate better terms with suppliers so you’re not stuck with more inventory than you can sell

Pay suppliers more effectively

• Negotiate longer payment terms to keep cash in your business for longer

• Take early payment discounts if you can, but only if it doesn’t stretch your cash flow

• Don’t pay bills much earlier than they’re due – but make sure you keep suppliers happy

Use the right finance

• Replace expensive overdrafts with cheaper term loans

• Use asset based finance if you’ve got valuable equipment or stock to borrow against

• Set up a revolving credit facility so you only pay interest on what you actually use

Increase profits and plan ahead

• Check your pricing – are you making enough profit on each sale?

• Cut unnecessary costs to keep more cash in the business

• Create a cash flow forecast to spot potential shortfalls before they happen

Example of improving working capital

A shop has a working capital ratio of 0.9, meaning they’re struggling to cover their bills. They decide to take three simple steps to improve it:

• Give customers a 10% discount for early payment, cutting the time they wait for cash from 45 to 30 days

• Negotiate 60-day payment terms with suppliers instead of 30 days

• Sell off old stock at a discount to free up £15,000 in cash

Their working capital ratio increases to 1.4, giving them much-needed financial breathing space.

Working capital finance

If you need to boost your business’s cash flow, you can choose from a range of finance options designed for short-term needs. Unlike traditional business loans, working capital finance gives you quick access to funds without tying you into long-term repayments.

• Working capital loans: Borrow £1,000 to £20 million for 3-24 months, with interest rates typically between 7-20% APR. You’ll usually get a decision in 1-3 days, making these loans ideal for covering unexpected bills or filling temporary cash flow gaps.

• Invoice finance: Get up to 90% of your unpaid invoices’ value paid into your account within 24-48 hours. You’ll pay a 1-3% fee plus interest on the amount advanced, so you’re only borrowing against money you’re already owed. This can be helpful if you’re waiting on customer payments.

• Merchant cash advance (MCA): Receive £5,000 to £1 million upfront, then repay it automatically as a small percentage of your daily card sales. MCAs are fast and easy to access, but costs can be high – expect factor rates of 1.1-1.5 (which can equate to 30-100%+ APR). They work best for businesses with steady card revenue, like shops, cafes, or salons.

• Asset based loans: Borrow against what your business already owns (eg stock, equipment, property, or even intellectual property). This could be a suitable option if you have valuable assets but need liquidity.

• Business credit cards or overdrafts: These can be useful for smaller, short-term expenses, like restocking or emergency repairs. Just be mindful that interest rates can be high so you’ll want to repay the credit within the month.

Working capital and Making Tax Digital for Income Tax

Making Tax Digital for Income Tax (MTD ITSA) is changing how UK sole traders and landlords track their finances. While it doesn’t change how you calculate working capital, it will make monitoring it much simpler – helping you stay on top of your cash flow.

With MTD, you’ll keep digital records and send quarterly updates to HMRC. This will give you:

• Real-time visibility of your working capital, so you can spot trends like slow-paying customers or rising costs early

• Accurate, up-to-date records of what you’re owed and what you owe, making it easier to plan for tax payments and supplier bills

• Clearer insights into important metrics like debtor days (the average number of days it takes to receive payments from your customers) and stock turnover, so you can act quickly if you notice numbers starting to slip

Wrapping up

Working capital is the backbone of your business’s financial health. It’s what covers energy costs, keeps stock replenished, and pays your suppliers. If you understand how to calculate and manage working capital, you’ll be able to avoid cash flow issues, plan for growth, and make financial decisions more effectively.

Here’s a reminder of the key points:

• Working capital = Current assets - Current liabilities. It’s a simple but powerful way to measure your short-term financial health.

• A working capital ratio of 1.2-2.0 is ideal for most UK businesses. If you’re operating below 1.0, take action immediately.

• You can improve working capital by speeding up receivables, optimising inventory, and managing payables more strategically.

• Making Tax Digital (MTD) for Income Tax makes tracking working capital easier by enforcing digital record-keeping.

• Working capital finance options like loans, invoice finance, or merchant cash advances can help boost your cash flow.

Working capital FAQs

What’s the difference between working capital and cash flow?

Working capital measures your business’s short-term financial health by comparing what you own (current assets like cash, unpaid invoices, and stock) to what you owe (current liabilities like bills and taxes). It’s a snapshot of whether you can cover your immediate costs.

Cash flow tracks the actual money moving in and out of your business over time, like payments from customers and bills you pay. You could have positive working capital but still experience cash flow issues if customers pay late. Or you might have strong cash flow in one month (from a big payment) but still struggle if lots of bills are due at once.

What’s the difference between working capital and liquidity?

Liquidity is about how quickly you can turn assets into cash to pay your bills. It’s usually measured by ratios that focus on your most liquid assets, like cash and receivables, while ignoring slower-moving items like stock.

Working capital is simply your current assets minus your current liabilities. So you could have high working capital but low liquidity if your money’s tied up in unsold stock. Or you might have low working capital but high liquidity if you get paid quickly and keep minimal stock.

What’s the difference between working capital and equity?

Equity is the long-term value of your business – it’s what’s left after all debts are paid. It includes retained profits, investments, and reserves, showing your business’s net worth over time.

Working capital is more about the here and now – can you pay your immediate bills with the assets you have? Even if your business is profitable (strong equity), you could still face working capital shortages if cash is tied up in stock or unpaid invoices.

Photo by Sergey Zolkin on Unsplash