Working capital: how much does a business need?
What working capital is, how to work it out from your balance sheet, when a negative figure is a warning, and why too much can also be a problem.
By Achekam · · 4 min read · For Running a business businesses in South Africa, Nigeria, Kenya
Of all the figures on a small business's balance sheet, working capital answers the most practical question: if the business had to settle everything it owes in the coming year out of what it will turn into cash in the coming year, could it? Profit says whether the business is worth running. Working capital says whether it can keep running while it waits to be paid.
The calculation is simple. Interpreting it takes more care, because the right amount differs a great deal between a supermarket, a contractor and a consultancy.
Current assets less current liabilities
ACCA defines working capital as current assets less current liabilities, representing the net current assets available for day-to-day operating activities. Investopedia gives the same formula and notes that it is also known as net working capital.
Working capital = current assets − current liabilities
Current assets in a small business usually include:
- cash and bank balances;
- trade receivables (what customers owe);
- inventory;
- prepayments and other short-term amounts owed to the business.
Current liabilities usually include:
- trade payables (what you owe suppliers);
- VAT, PAYE and other taxes due;
- accrued expenses and wages owed;
- the part of any loan repayable within the year;
- an overdraft;
- deposits and other money received in advance.
What "current" means
Investopedia explains that "current" means a period of one year or less: current assets can be turned into cash within 12 months, and current liabilities must be paid within the same period.
That one-year line matters when you classify things. A loan repayable over five years is split: the next year's repayments are current; the rest is not. Stock that has sat in the back room for two years and will not sell is technically a current asset, but it will not pay any bills. Working capital is only as good as the quality of the items inside it.
Negative working capital: warning or normal?
Investopedia explains that negative working capital, where current liabilities exceed current assets, is a warning sign of more short-term debt than short-term resources, although a short spell of it may not be a problem depending on where the business is in its life cycle.
Read a negative figure in context:
- A warning when it comes from an overdraft funding losses, or from suppliers and taxes going unpaid because cash is short.
- Less worrying when it comes from customers paying in advance. A business that collects deposits or annual fees before delivering can carry large current liabilities that are settled by doing the work, not by paying out cash.
- A passing phase for a young business that has just bought equipment or stock and expects receipts to follow within months.
Whatever the cause, a negative figure deserves a cash forecast that shows how the next few months will be met.
Too much: idle cash and excess stock
Owners rarely worry about having too much working capital, but Investopedia warns that a very high figure can point to too much inventory or excess cash that is not being used well.
A large working capital figure built from slow-paying customers and overstocked shelves is not strength. It is money tied up where it earns nothing. Cash beyond what the business needs could repay expensive debt or fund growth. Stock beyond what sells may need to be cleared before it dates.
How much does your business need?
Investopedia notes that the amount of working capital a business needs varies by industry, size and risk profile, with longer production cycles requiring more. A few examples of why:
| Business | Why its need is high or low |
|---|---|
| Supermarket | Low: customers pay at the till, suppliers are paid later |
| Contractor | High: materials and labour are paid long before progress payments arrive |
| Manufacturer | High: raw materials, work in progress and finished goods all tie up cash |
| Consultancy | Moderate: few stock costs, but fees are often paid weeks after the work |
Rather than chase a single "right" figure, compare your working capital with your own history and with your forecast. A steady decline over several months, without a planned reason, is the signal to act.
Reading the figures from your balance sheet in Achekam
Achekam's management accounts include a balance sheet at period end, added up from the business's own journals and exportable as PDF or CSV. The trial balance can also show each account at a date. From either:
- Add up the current asset accounts: bank, receivables, inventory, prepayments.
- Add up the current liability accounts: payables, taxes, accruals, overdraft, the current portion of loans, deposits received.
- Subtract the second from the first.
- Repeat for the same date last month and last year, and compare.
Check quality as well as quantity. Receivables are aged into 0-30, 31-60, 61-90, 91-120 and over 120 days, so you can see how much of the receivables figure is old enough to doubt.
A note for Nigerian and Kenyan businesses: at the time of writing, the ledger screens show every amount in rand and the chart of accounts is stored in ZAR, even for a Nigerian or Kenyan business. The working capital arithmetic is unaffected, but read the currency label with that in mind.
For the cash side of the same story, see why a business can show profit but have no cash, and for what lenders do with these figures, bank facility figures for contractors.
Further reading
Investopedia's article on working capital, its formula and its limits covers the components in more detail. Work out your working capital at the last three month-ends, and ask your accountant what level suits a business of your type and size.
General guidance only, not advice on your own circumstances. Tax and payroll rules change: check the current position with the authority or your adviser.
