What is working capital?

business.gov.au describes working capital as “the cash available to a business for day-to-day expenses”. It pays for stock, wages, rent and suppliers while you wait for customers to pay you.

The formula in words

Working capital is your current assets minus your current liabilities.

• Current assets are cash, or things you can turn into cash within 12 months. That includes money in the bank, stock, money customers owe you (accounts receivable) and expenses you have paid in advance.
• Current liabilities are amounts due for payment within 12 months. That includes supplier bills (accounts payable), credit cards, wages you owe, and tax you owe.

Both figures come from your balance sheet. Your accounting software or your accountant can produce one for any date.

A worked example

Here is a small wholesale business on 30 June.

Current assets	Amount
Cash in the bank	$20,000
Customers who owe money	$50,000
Stock	$30,000
Total	$100,000

Current liabilities	Amount
Supplier bills	$35,000
Tax owed	$15,000
Wages and super owed	$10,000
Credit card	$5,000
Total	$65,000

Working capital is $100,000 minus $65,000, which is $35,000.

That looks healthy, but look at what the $100,000 is made of. Only $20,000 is cash. The other $80,000 depends on customers paying and stock selling. If the largest customer, who owes $25,000, pays a month late, the business may not have enough cash to pay its suppliers on time, even though its working capital is positive.

This is why working capital and cash flow need to be read together.

The working capital cycle

Most businesses go through the same loop:

1. You buy stock or materials, or pay staff to do the work.
2. You make, hold or deliver the product or service.
3. You send an invoice.
4. You wait for the customer to pay.
5. The cash comes in and you pay your own bills.

The time between paying out (step 1) and getting paid (step 4) is the gap your working capital has to cover. For example, say your suppliers give you 30 days to pay, your stock sits on the shelf for 45 days and your customers take 45 days to pay. You then carry the cost of each sale for about 60 days before the cash comes back.

The longer the gap, the more working capital you need. As a business grows, the gap grows with it, because you pay for more stock and wages before the extra sales turn into cash. For how to measure the gap, see how much working capital do you need?

How to improve working capital without borrowing

Start with the parts of the cycle you control. The business.gov.au cash flow guidance suggests several of these.

• Invoice sooner. Send the invoice when the customer buys, not at the end of the month. Make your payment terms and payment methods clear on every invoice.
• Tighten payment terms. Ask for deposits or part-payment upfront on large jobs. Check a customer’s credit before you offer them credit, and set a credit limit.
• Follow up late payers quickly. A polite reminder on the day after the due date works better than a stern letter weeks later. See what to do when customers pay invoices late.
• Hold less stock. Make sure stock levels are not too high, and clear out stock that isn’t selling.
• Talk to suppliers. Ask whether longer terms are possible, but keep paying on the terms you agree.
• Review your costs and prices. Cut spending that no longer earns its keep, and check that your prices cover your costs.
• Sell what you don’t need. Equipment or vehicles sitting idle are cash you could use.
• Set aside tax and super. Keep money for GST, PAYG withholding and super in a separate account so it is there when it falls due.

Step by step

1. Get a current balance sheet from your accounting software or accountant.
2. Add up current assets and current liabilities, and take one from the other.
3. Check the quality of your current assets. How much is cash? How old are the unpaid invoices? Is any stock slow to sell?
4. Work out your own working capital cycle: how long you hold stock, how long customers take to pay and how long you take to pay suppliers.
5. Prepare a cash flow forecast for at least the next three months so you can see when cash will be tight.
6. Choose two or three of the improvements above and track the result each month.
7. Talk to your accountant about what the numbers mean for your business.

Where finance can fit

Once you have done what you can inside the business, finance may help with a timing gap, such as a seasonal stock build or a large customer with long payment terms. It works best when the business is profitable and the gap is temporary and predictable.

Options include a business line of credit, invoice finance and short-term cashflow loans. Our guide to a line of credit vs a term loan explains how the first two differ. You can also compare working capital finance.

Finance does not fix a business that is losing money. If you are borrowing to cover a shortfall that keeps coming back, read when borrowing is not the answer first.

Important things to know

• Working capital is a snapshot. It shows one day. Your cash position can change sharply a week later when a big bill falls due.
• Profit is not cash. A profitable business can still run out of cash if customers pay slowly or stock builds up.
• Some money is not yours to spend. GST you have collected, PAYG withholding and super are owed to others. Counting them as spare cash can create a tax debt.
• Growth uses working capital. Winning a large new contract can leave you shorter of cash, not longer, until the customer pays.
• Warning signs matter more than the number. If you are paying bills late or using personal money to keep going, read cash flow warning signs and talk to your accountant.