What is working capital? A plain-English guide for UK companies

Working capital is the money a business has available to run day to day. It is calculated as current assets minus current liabilities. Positive working capital means a company has more short-term resources than short-term debts; negative working capital means the opposite.

Current assets are things that are cash or should turn into cash within a year, such as money in the bank, stock and invoices customers have not yet paid. Current liabilities are amounts due within a year, such as supplier bills, VAT and PAYE owed to HMRC, overdrafts and the next twelve months of loan repayments.

Working capital matters because bills are paid in cash, not profit. A company can be profitable and still struggle to pay wages if too much of its money is sitting in stock or waiting on customers.

The basic formula is: working capital = current assets minus current liabilities. The related working capital ratio, also called the current ratio, is current assets divided by current liabilities.

The ratio shows how many times over a company could cover its short-term debts from its short-term assets. A ratio below 1 suggests the company may struggle to meet its short-term obligations. A very high ratio is not always good either, because it can mean cash is sitting idle or stock is building up.

Some lenders and accountants also look at the quick ratio, which leaves stock out of current assets because stock can take time to sell. This gives a more cautious view of how easily a company could pay what it owes in the short term.

Not always. Negative working capital is a warning sign for many companies, but some business models run that way safely because customers pay before suppliers have to be paid.

A restaurant or a retailer paid by card at the till, for example, may receive cash immediately while paying suppliers on 30 day terms. Its current liabilities can exceed its current assets without any real strain. A contractor that invoices on 60 day terms and pays staff weekly is in the opposite position, and negative working capital there is far more likely to mean pressure.

What matters is the trend and the reason. Working capital that is falling year after year, rising arrears with HMRC or suppliers, and a growing reliance on an overdraft all suggest the cycle needs attention.

Each sector has its own natural cycle, so a healthy position in one industry may be a stretched one in another. These hypothetical examples show the range:

• A manufacturer buys raw materials, holds work in progress and finished goods, then invoices business customers. Cash can be tied up for months.
• A recruitment agency pays temporary workers weekly but may wait 30 to 60 days for clients to pay, so its cycle is driven almost entirely by debtor days.
• A wholesaler carries large stock and gives credit to retailers, so both stock days and debtor days matter.
• A hospitality business is mostly paid immediately and may have a short cycle, but faces seasonal swings in takings.

Comparing your figures with your own past performance usually tells you more than comparing with an unrelated business.

The working capital cycle is the time between paying out cash for stock, materials or labour and receiving cash from customers. The longer the cycle, the more cash a company needs to fund it.

It is usually measured in days, using three figures:

• Stock days: how long stock is held before it is sold.
• Debtor days: how long customers take to pay.
• Creditor days: how long the company takes to pay its suppliers.

The cycle is stock days plus debtor days, minus creditor days. A manufacturer that holds raw materials, builds products and then invoices on 60 day terms will usually have a long cycle. A business paid at the point of sale, with little stock and credit from suppliers, may have a very short or even negative cycle.

Growth usually needs more working capital, not less. Each extra sale means buying more stock and paying more staff before the customer pays, so more cash is tied up in the cycle.

In the example above, if sales rose by a third with the same payment terms, debtors alone would rise by about £60,000. A company that grows quickly without planning for this can run short of cash despite healthy orders. This is often called overtrading, and it is one of the most common reasons profitable businesses need short-term finance.

Seasonal businesses face a similar squeeze. A company that builds stock ahead of a busy period carries the cost for weeks or months before sales arrive.

Most improvements come from shortening the cycle: collecting cash sooner, holding less stock and agreeing sensible supplier terms. Practical steps include:

• Invoice promptly and accurately: errors and late invoices delay payment.
• Agree and enforce payment terms: chase overdue invoices consistently and consider deposits or staged payments on large orders.
• Check customer credit: avoid building large balances with customers who pay slowly.
• Manage stock: buy closer to when it is needed and clear slow-moving lines.
• Negotiate with suppliers: agree longer terms where possible, rather than simply paying late, which can damage relationships and your credit record.
• Plan for tax: set aside VAT and PAYE as they build up, and talk to HMRC early if a payment will be difficult, as Time to Pay arrangements exist.
• Forecast cash flow: a rolling forecast shows pressure points before they arrive.

Our guide to building a cash flow forecast for lenders is a useful starting point. An accountant can also help review your working capital position.

When improvements to the cycle are not enough, finance can bridge the gap. The right option depends on where the cash is tied up.

• Invoice finance: releases a percentage of unpaid invoices, so funding grows with sales. See invoice finance.
• Revolving credit facility: a limit your company can draw, repay and redraw as needs change. See revolving credit facility.
• Working capital loan: a lump sum repaid over a fixed term, useful for a defined need. See working capital finance.
• Stock and trade finance: funds the purchase of stock or goods from suppliers. See stock finance.
• Merchant cash advance: an advance repaid from future card takings, usually more expensive than other options.

Before taking any working capital finance, check the total cost, the notice period and any minimum term, whether a personal guarantee or a debenture is required, and how repayments fit your cycle. Short-term debt used to fund a long-term problem can make the position worse, so be clear about how the finance will be repaid. Lending to limited companies, LLPs and partnerships of four or more partners is usually unregulated, so read the terms carefully. Our cash flow finance section compares these products side by side.

Lenders use working capital as a sign of short-term financial health. They typically look at the working capital ratio in your accounts, the trend over time, debtor and creditor days, and whether short-term debts, especially to HMRC, are under control.

Negative working capital does not automatically mean a decline, particularly if the business model explains it. A clear explanation and a realistic forecast help the lender understand the position.

Welcome Finance is a commercial finance broker, not a lender. We check your company's eligibility in about 60 seconds without affecting its credit score, then introduce you to suitable lenders on our panel for the type of working capital support that fits your cycle. Lenders run their own credit checks once you decide to apply and make their own decisions.

Your dedicated relationship manager is available by phone, email and chat until the lender pays out. We don't charge you a fee. We are paid a commission by the lender when your finance completes, and you can ask how much it will be. Commission can differ between lenders.