Your guide to working capital finance

Different businesses require different amounts of working capital based on their individual expenses, assets, and liabilities. For instance, a retail business requires lots of available cash for purchasing inventory and maintaining a storefront, while a tech company operating remotely might not have the same regular costs. 

Ultimately, determining if you need working capital finance comes down to your working capital balance. If you find your liabilities often outweigh your assets, you might need a working capital boost. 

All forms of finance come with risks and drawbacks, and working capital is not an exception. Here are some of the things you might want to consider before hitting apply. 

Entering into a cycle of debt 

Taking out short-term debt can push you into a debt cycle, where you consistently take out more debt to pay off the old debt. This can result in you eventually becoming more reliant on external sources of finance than on the pay you receive from customers. Be careful when entering into financial agreements, ensure you have all the facts, and carefully consider your ability to repay and manage debt. 

It doesn’t solve the underlying issue 

Working capital finance is a helpful way to resolve short-term working capital issues and enable growth, but if your working capital is regularly in the negative, taking out finance is only a quick fix and doesn’t resolve the real problem. 

Credit score

Applying for working capital finance can involve the lender adding a hard search to your personal or business credit report, which could negatively impact your score. Not only that, but while repaying your loan on time and consistently can have a positive effect on your score, missing payments or defaulting on the loan can have a negative impact, affecting your ability to borrow in the future. 

Whether or not you need working capital finance depends a lot on your current financial health. If you’re struggling with negative working capital, this type of finance might be suitable to you. 

Ask yourself:

• Is my working capital positive or negative?

• Can I pay my suppliers, employees, and loans next month?

• Am I capable of repaying any finance I receive?

• Do I need to add new hires or purchase any new equipment to support an upcoming busy period?

• Is there an opportunity I want to take advantage of that I simply don’t have the cash for today, but I will have the cash for once the deal is finalised?

• Have I had to turn down any business recently because I haven’t had the funds to support the project?

Example: Let’s say you run a fancy dress store. Your biggest seasons are Easter, Halloween, and Christmas. In September, you don’t have the funds to purchase your inventory in advance of Halloween. By 3 November, you’ll have everything you need, but by then it will be too late and you’ll have missed out on the sales. In this instance, working capital could help you purchase the required stock to help you manage this seasonal variation.

Working capital is the money you use to run your business on a day-to-day basis. 

The definition of working capital is the amount of money left over after you subtract your current liabilities (everything you owe in the next 12 months) from your current assets (everything you could quickly turn into cash in the next 12 months). It is a financial metric that measures your company's liquidity and efficiency over the short term. Calculating working capital is an important way to understand your company’s financial health. 

Strong working capital management is absolutely essential to your success as a business, as without it, it’s possible to miss bill or loan payments, lose out on exciting deals, or even lose your office premises. That’s because money can flow in and out of a business quite quickly, and it’s entirely possible to have a large sum of cash in the bank at the moment, but for your current liabilities to amount to more than both the cash in the bank and any money owed to you in invoices. 

This could mean your finances could be in a precarious state without you noticing, as funds can deplete as liabilities turn due. That’s why relying on a current snapshot of your bank balance can be misleading and it’s essential to generate a more accurate picture of your financial health. 

But having too much working capital can be a problem too. 

Let’s say the amount owed to you by clients and the amount of inventory you currently hold far surpass the amount you owe in rent and bills in the coming months. This excess working capital could mean you’re missing out on opportunities for investment and growth. 

By calculating your working capital, if you find you have more than expected and required for a healthy business to run, that could be the catalyst you need to expand your opportunities, penetrate new markets, or increase your marketing efforts. 

Let’s put this into context. Greg runs a small restaurant business. 

He needs to buy ingredients, pay his staff and cover his rent and bills. These are his short term expenses, or liabilities. 

To pay these expenses, Greg has cash in the till from customers paying their restaurant bill. These are his current assets.

Working capital is the difference between the amount of cash Greg has in the register, minus the amount he needs to pay to cover the costs mentioned above. 

If the resulting number is a positive number, meaning above zero, then he has positive working capital. If the number is very high, he could potentially use some of that cash to expand his restaurant business by buying a secondary residence, launching a marketing campaign, or developing new recipes. 

If the resulting number is below zero, he has negative working capital. It’s a good thing he calculated this in advance and can now address the issue before it takes him by surprise. If he hadn’t, he might find he’s unable to pay his staff or buy the ingredients he needs to serve his customers, which could force him to shut down. 

Before you can determine your funding needs, you need clear oversight of your current working capital.

To calculate your working capital, subtract your current liabilities from your current assets. Your working capital assets to liabilities ratio should fall between 1.2 to 2.0. A ratio below a 1.0 can indicate cash flow problems to your accounting team and investors.

For example, if you have £5,000 in the bank, a customer that owes you £4,000, an invoice from a supplier payable for £2,000, and a VAT bill worth £4,000, your working capital would be £3,000.

Here’s a breakdown of that equation:  

Assets (5,000 + 4,000) – Liabilities (2,000 + 4,000) = Working Capital 3,000

Here are some terms you may encounter as you learn more about this helpful financial measurement: 

• Current assets: While assets are anything owned by the company that will provide value over the next year (eg a car, a house, cash, money owed to the business), current assets are more specific. They are any assets that could be turned to liquid cash within the next year. Net current assets or short-term assets are two other terms used to describe this. 

• Current liabilities: These are any debts or outgoings that you must pay within the next year. Short-term debt or short-term liabilities are two other ways to say this. 

• Working capital cycle: Also written as WCC, your working capital cycle is how long it would take your business to turn your current assets and current liabilities into cash. Essentially, if you purchase stock, the invoice from your supplier is a liability and the stock could count as an asset, but the stock isn’t cash. Consider how long it would take you to go from there to the customer purchasing that stock and handing over the funds. The longer this cycle is, the more strained your working capital may be. 

• Finished goods: This is anything that exists in its final form but has not yet been sold onto a customer. For example, let’s say you manufacture motorbikes. A completed bike that’s sitting in the warehouse or shop floor would be a finished good. 

• Accounts payable: Your accounts payable is what you owe your suppliers. It’s considered a liability. An example would be an invoice your lightbulb supplier sent you that you haven’t gotten around to paying yet. 

• Balance sheet: A balance sheet helps you gain a better understanding of your company’s financial health. It includes all assets, liabilities, and equity. 

• Operating expense: This is what it costs you to run the business as usual. 

• Inventory turnover: This is how quickly your business sells and replaces its inventory. 

Businesses face serious cash shortages on a surprisingly regular basis. In fact, in the UK, mid-market companies are hit with a cash shortage surpassing £50,000 14 times a year, with a little over a third of those same companies encountering significant cash shortages on a monthly basis. 

Smart working capital management can fuel growth. It is vital to the success of all businesses, small, medium, and large. And with 82% of businesses that fail citing cash flow as their reason for shutting down, and working capital management playing a direct role in maintaining successful cash flow, it’s clear that gaining the foundational knowledge necessary to manage your working capital is vital to business success. 

Positive working capital means you have more liquid assets than liabilities, which means you may be able to use some of those assets to facilitate growth. In a nutshell, it means there may be extra cash in your business that you can use to fund marketing or expansion activities.

Negative working capital means you owe more than you have, which can result in your business falling into debt, missing payments, being unable to pay suppliers and employees, or even defaulting on a loan.

It’s important for businesses to understand which camp they’re in so they can make the necessary arrangements – expansion if they have positive working capital, or, increasing income or reducing expenses if they have negative working capital.

Here are some tips to get you started on your working capital journey: 

• Keep a budget: Keeping a monthly budget that tracks all income and expenses can help you ensure your business always has enough capital to meet its short term obligations.

• Review your expenses: Consider if there are any areas you can save in, for instance, you may be able to negotiate with your suppliers for better rates or there might be expenses you could cut out all together.

• Upsell and cross-sell: 37% of sales people avoid upselling, but of the sales people who do engage in upselling, they make an average 30% more in revenue. Not only that, but upselling can boost customer lifetime value by 20-40%. Both cash and unpaid invoices count as assets, so if yours are dwindling, consider upselling and cross-selling.

• Emergency fund: A company emergency fund can help ensure you still have the funds to meet your obligations even if your working capital needs a little smoothing out from time to time.

• Chase invoices: 2 million British SMEs were paid late last year, according to NatWest. Late payment can have a significant impact on working capital. If possible, follow up on any invoices once they become due.

• Manage inventory: If you have too much, or too little working capital, consider reviewing your inventory to assess if you are purchasing a surplus and extending your sales cycle unnecessarily.

• Reduce your payment terms: Standard payment terms for B2B businesses are generally 30, 60, or even 90 days from when the invoice is raised, which can present an issue to new and small businesses, particularly if you have to pay suppliers before payment is made by the client. If you’ve noticed you have cash flow difficulties, consider reducing the amount of time you give clients to pay. Alternatively, you could consider invoice finance, specifically, invoice discounting.  

Working capital provides an in-the-moment snapshot of your business’s financial health, but it doesn’t dive into your ability to manage cash flow long term, your projected income, or your profitability.

Not to mention, let’s say you spent an unprecedented amount on inventory last month – your working capital may be negative but that doesn’t necessarily mean it won’t settle out into positive in the upcoming months. Working capital also doesn’t take into consideration your potential for growth, your ROI, or how much debt you may have.

Ultimately, while working capital can help you understand where you’re positioned as far as short-term liquidity, a more complete financial picture is required when making long-term impactful business decisions.