Working Capital: What It Is and Why It Matters

What Is Working Capital?

Working capital is the difference between your current assets and your current liabilities. In simple terms, it is the money available to fund your daily operations.

Working Capital = Current Assets - Current Liabilities

Current assets include cash, accounts receivable (money owed to you), and inventory. Current liabilities include accounts payable (money you owe), upcoming loan repayments, tax liabilities, and accrued expenses.

If your working capital is positive, you have more short-term assets than short-term obligations - you can pay your bills and have money left over. If it is negative, you owe more than you have available, and you may struggle to meet your obligations.

Why Working Capital Matters

Working capital is the operational lifeblood of your business. It funds:

• Paying suppliers for materials before you sell the finished product
• Covering wages while waiting for clients to pay invoices
• Holding inventory until it is sold
• Meeting tax obligations as they fall due
• Handling unexpected expenses or delays

Without adequate working capital, even a profitable business can fail. Profit is an accounting concept - it tells you whether your revenue exceeds your expenses over a period. Working capital is a cash reality - it tells you whether you can actually pay your bills today.

The Working Capital Cycle

Every business has a working capital cycle - the time between spending money on inputs and receiving payment from customers.

Example - Product business:

1. You buy inventory (cash goes out)
2. Inventory sits in your warehouse (cash is tied up)
3. You sell the inventory (revenue is recognised)
4. You wait for the customer to pay (cash comes in)

The total time from step 1 to step 4 is your cash conversion cycle. The longer this cycle, the more working capital you need.

Example - Service business:

1. You incur costs to deliver the service (wages, materials, travel)
2. You complete the work and invoice the client
3. You wait for the client to pay

Service businesses generally have shorter cash conversion cycles than product businesses, but the principle is the same.

Calculating Your Working Capital

Pull your balance sheet and identify:

Current Assets:

• Cash at bank: $25,000
• Accounts receivable: $40,000
• Inventory: $15,000
• Prepaid expenses: $3,000
• Total current assets: $83,000

Current Liabilities:

• Accounts payable: $20,000
• Credit card balances: $5,000
• GST/BAS payable: $8,000
• Super payable: $4,000
• Current portion of loans: $12,000
• Total current liabilities: $49,000

Working Capital: $83,000 - $49,000 = $34,000

This means you have $34,000 of buffer between what you have and what you owe. Whether this is adequate depends on your monthly expenses and the volatility of your cash flows.

Working Capital Ratios

Current Ratio

Current Ratio = Current Assets / Current Liabilities = $83,000 / $49,000 = 1.69

A ratio above 1.5 is generally healthy. Between 1.0 and 1.5 is adequate but tight. Below 1.0 means you may not be able to cover your short-term obligations.

Quick Ratio

Quick Ratio = (Cash + Accounts Receivable) / Current Liabilities = ($25,000 + $40,000) / $49,000 = 1.33

This excludes inventory (which may be slow to convert to cash). A quick ratio above 1.0 is healthy.

Optimising Working Capital

Accelerate Receivables

The faster your clients pay, the less working capital you need:

• Invoice immediately upon completing work (do not wait)
• Set clear payment terms (7-14 days for most businesses)
• Offer early payment discounts (e.g., 2% discount for payment within 7 days)
• Follow up on overdue invoices promptly and consistently
• Consider requiring deposits for large projects
• Use direct debit for recurring clients

Manage Inventory Efficiently

For product businesses, inventory ties up cash:

• Track inventory turnover and reduce slow-moving items
• Use just-in-time ordering where possible
• Negotiate consignment arrangements with suppliers
• Conduct regular stock counts to identify dead stock

Negotiate Payable Terms

Longer payment terms with suppliers preserve your cash longer:

• Negotiate 30-day terms if you are currently paying on delivery
• Take advantage of the full payment term (do not pay early unless discounts apply)
• Build strong supplier relationships that support flexible terms

Manage Tax Cash Flow

Tax obligations can create significant cash flow demands:

• Set aside GST collected in a separate account as you earn it
• Budget for quarterly super payments
• Arrange PAYG instalments that match your actual income

Working Capital Traps

Rapid Growth

Fast-growing businesses often face a working capital squeeze. Revenue is increasing, but cash is consumed by inventory purchases, new hires, and expanding operations. The gap between spending money and receiving money widens.

Seasonal Fluctuations

Seasonal businesses may have strong working capital during peak periods but negative working capital during quiet months. Plan for this cycle and build reserves.

Over-Investment in Fixed Assets

Spending too much on equipment, vehicles, or property leaves less cash available for working capital. Balance capital investment with operational cash needs.

Customer Concentration

If a large portion of your receivables depends on one or two clients, a delayed payment from them can create an immediate working capital crisis. Diversify your client base where possible.

Monitoring Working Capital

Check your working capital position at least monthly:

1. Review your balance sheet
2. Calculate working capital and the current ratio
3. Review your aged receivables (are collections on track?)
4. Review your aged payables (are you managing terms effectively?)
5. Check your cash position against upcoming obligations

SortBooks keeps your transaction data categorised and current, so your balance sheet accurately reflects your working capital position. Reliable data is the foundation of effective working capital management.

Working capital is not glamorous, but it is essential. Monitor it regularly, optimise the cycle, and ensure you always have enough financial fuel to keep your business running.