Your business is selling, your clients are good, and yet the bank account is tight at the end of every month. It is often a working capital question. Here is how to calculate it, how to read it, and when it is worth financing.
The working capital formula
Working capital is what is left when you subtract your short-term debts from your short-term assets.
Working capital = current assets − current liabilities
- Current assets: cash in the bank, accounts receivable (the invoices your clients owe you) and inventory.
- Current liabilities: accounts payable, debts due within the year, and the part of your loans to be repaid in the next 12 months.
You will find these figures on your balance sheet, under "current assets" and "current liabilities".
A worked example
Take a fictitious business.
- Cash: $40,000
- Accounts receivable: $130,000
- Inventory: $80,000
- Current assets: $250,000
- Accounts payable: $60,000
- Other short-term debts: $120,000
- Current liabilities: $180,000
Its working capital is $250,000 − $180,000 = $70,000.
People also look at the ratio: $250,000 ÷ $180,000 = 1.39. A ratio above 1 means current assets exceed short-term debts. A ratio below 1 is a sign of pressure to watch.
The working capital requirement
Working capital tells you whether you are covered on paper. The working capital requirement tells you how much money stays tied up in your business cycle.
Working capital requirement = inventory + accounts receivable − accounts payable
In our example: $80,000 + $130,000 − $60,000 = $150,000.
That amount is the money the business has to carry: goods bought but not yet sold, and invoices sent but not yet paid. The later your clients pay, and the larger your inventory, the bigger this requirement gets.
Why good working capital is not enough
Positive working capital does not guarantee the money is there at the right time. The business in our example has $70,000 on paper, but $130,000 is sitting in its receivables. If its clients pay at 60 or 90 days while payroll and suppliers go out every week, the bank account stays tight.
That is exactly where the calculation helps: it shows whether the problem comes from inventory, from your clients' payment terms, or from short-term debts that are too heavy.
When to finance the gap
Financing makes sense when the need is clear, with a beginning and an end:
- a contract to start before the client's first payment;
- a slower season to get through while keeping your employees;
- inventory to buy before a busy period;
- solid clients who pay late.
Two solutions answer two different situations:
- Working capital financing is for a specific need, such as a contract or a season. Lenders mainly look at your recent bank statements, and generally ask for a personal credit score of 700 or more. The funds are not used to repay another cash flow loan. Details are on the Working capital page.
- Factoring fits when the problem is your receivables: your invoices to other businesses are the basis of the financing, and the amount available follows your sales. See the Factoring page.
Working capital is not a last resort. If the business is going through serious difficulties, it is better to talk about it openly before submitting a file.
Key takeaways
- Working capital = current assets − current liabilities.
- Working capital requirement = inventory + accounts receivable − accounts payable.
- A positive number is not enough: also look at when the money comes in and when it goes out.
- For accounting and tax matters, check with your accountant.
Want to know if your situation can be financed? A single application can be presented to more than 10 partner lenders.