What is working capital?
Working capital is the difference between a business’s current assets and current liabilities.
It indicates whether the business has sufficient short-term resources to meet its short-term obligations.
The formula is:
Working Capital = Current Assets − Current Liabilities
Current assets can include:
- Cash and bank balances.
- Customer invoices expected to be collected.
- Stock intended for sale.
- Other short-term assets.
Current liabilities can include:
- Supplier accounts.
- Short-term loans.
- Overdrafts.
- Tax obligations due.
- Other short-term financial commitments.
Example: Calculating working capital
A small retail business has the following position:
| Current assets | Amount |
|---|---|
| Bank balance | R35,000 |
| Customer invoices | R25,000 |
| Stock | R60,000 |
| Total current assets | R120,000 |
Its current liabilities are:
| Current liabilities | Amount |
|---|---|
| Supplier accounts | R40,000 |
| Short-term loan obligations | R15,000 |
| Tax and other short-term obligations | R5,000 |
| Total current liabilities | R60,000 |
Working capital:
R120,000 − R60,000 = R60,000
The business has positive working capital of R60,000.
However, positive working capital does not necessarily mean that R60,000 is available in cash. Some of it is tied up in stock and unpaid invoices.
Why working capital matters
A business needs working capital to operate between the time it spends money and the time it receives money from customers.
For example:
A manufacturer buys timber, pays workers, purchases screws and finishes the furniture. The customer pays only after delivery.
The manufacturer needs enough working capital to cover the production expenses before receiving the final payment.
Without sufficient working capital, the business may struggle to complete orders even when the orders are profitable.
Understanding the working-capital cycle
The working-capital cycle measures how long cash remains tied up in inventory and customer receivables before returning to the business.
A simplified formula is:
Cash Conversion Cycle = Inventory Days + Receivable Days − Payable Days
Example:
| Component | Days |
|---|---|
| Stock remains in inventory | 30 |
| Customer takes to pay | 45 |
| Supplier payment period | 30 |
| Cash conversion cycle | 45 days |
The business needs to finance approximately 45 days of its operating cycle.
The lower the cash conversion cycle, the less time the business’s money is tied up, although the right balance depends on the business model.
How much working capital should you keep?
There is no universal amount that suits every business.
A retailer with fast-moving stock and cash sales has different working-capital needs from a construction company that waits 90 days for payment.
Consider these factors:
- Monthly operating expenses.
- Average customer payment period.
- Supplier payment terms.
- Stock turnover.
- Seasonal sales patterns.
- Existing debt repayments.
- Unexpected repair or maintenance costs.
- The size of confirmed orders.
A reserve of several months of operating expenses can provide protection, but businesses should build toward an appropriate buffer based on their own risks and cash cycle.
When should you borrow for working capital?
Borrowing may be appropriate when a business has a temporary funding gap linked to a confirmed commercial opportunity.
Example:
A business receives a confirmed R200,000 order. It needs R80,000 to purchase materials and pay production costs. The customer will pay once the order is completed and delivered.
A suitable short-term funding facility may bridge the gap.
However, borrowing to pay recurring expenses while the business consistently operates at a loss is a different problem. The business must first investigate its pricing, expenses and revenue model.
Ways to improve working capital without borrowing
Collect money faster
Request deposits, invoice immediately and follow up on outstanding payments.
Reduce slow-moving stock
Identify products that remain unsold and avoid unnecessary restocking.
Negotiate supplier terms
Where possible, negotiate payment terms that align with your sales cycle.
Control customer credit
Do not allow a few slow-paying customers to consume all available cash.
Improve stock purchasing
Buy according to demand rather than purchasing excessive quantities because of temporary discounts.
Review operating expenses
Remove unnecessary recurring expenses and renegotiate supplier costs.
Frequently asked questions
Yes. Stock and unpaid customer invoices may make current assets look healthy while the actual bank balance remains low.
No. Working capital measures short-term financial resources. Profit measures financial performance.
It is generally intended for day-to-day operations. Long-term equipment purchases should be assessed separately and financed in a way that matches the asset’s useful life.
Cash reserves are money readily available. Working capital also includes other current assets and current liabilities.
Can a business have positive working capital and still run out of cash?
Is working capital the same as profit?
Can working capital be used to purchase equipment?
What is the difference between working capital and cash reserves?
Your next action
Calculate your current working capital and then calculate your cash conversion cycle. These two figures will help you understand how much money is tied up in your daily operations.