Working capital is one of those terms that sounds more complicated than it is. Put simply, it’s the money your business needs to keep running day to day: the cash tied up in what customers owe you and the stock on your shelves, less what you owe your suppliers.
The basic calculation
Working capital = current assets − current liabilities
- Current assets: cash, money customers owe you (debtors) and stock.
- Current liabilities: money you owe suppliers (creditors), overdrafts and short-term loans, and tax due within a year.
Positive working capital means your short-term assets cover your short-term bills. But a big positive number isn’t automatically good news. It can mean a lot of cash is stuck in unpaid invoices and stock rather than sitting in the bank.
The cash conversion cycle
A more useful way to think about working capital is time. How long does it take for a pound you spend to come back to you as a pound received? That’s your cash conversion cycle, and it has three parts:
- Stock days: how long stock sits before it’s sold. Stock ÷ annual cost of sales × 365.
- Debtor days: how long customers take to pay. Trade debtors ÷ annual sales × 365.
- Creditor days: how long you take to pay suppliers. Trade creditors ÷ annual purchases × 365.
Cash conversion cycle = stock days + debtor days − creditor days
For example, if stock sits for 30 days, customers pay in 45 days and you pay suppliers in 30 days, your cycle is 45 days. That’s 45 days in which your business is funding its own sales.
Every day you take off the cycle is cash back in your bank.
Why growth can make it worse
As sales grow, debtors and stock grow too, usually before the cash from those sales arrives. That’s why fast-growing businesses can run short of cash even when they’re profitable, as our guide to why profit isn’t cash explains. It’s worth forecasting the working capital a growth plan will need before you commit to it.
How to free up working capital
- Shorten debtor days. Invoice promptly, agree clear terms and chase consistently. See our guide to getting paid faster.
- Reduce stock days. Review slow-moving lines and order little and often.
- Use creditor terms sensibly. Pay on time rather than early, and negotiate better terms where you can.
- Plan for growth. Build the extra working capital into your forecast so it doesn’t catch you out.
Measure it, then improve it
Work out your debtor, creditor and stock days once a quarter and you’ll quickly see where cash is getting stuck. A cashflow forecast built around those real numbers shows what improving each one would be worth to your bank balance. That’s the kind of analysis included in my Control and Partner services.
An accountant of ten years who has built more cashflow forecasts than hot dinners. I help owner-managed businesses see what’s coming and plan for it. More about me.