What is working capital? Definition and how to calculate it for your small business

Published Friday 5 December 2025

Table of contents

• What is working capital?
• The importance of working capital in business
• How to calculate working capital
• Working capital examples in different businesses
• What is net working capital?
• Working capital vs cash flow: what's the difference?
• How to manage your working capital
• Improve your working capital with Xero
• FAQs on working capital

Key takeaways

• Calculate your working capital by subtracting current liabilities from current assets to determine if you have sufficient funds to cover day-to-day operations and short-term obligations.

• Monitor your working capital ratio to maintain it between 1.2 and 2.0 for optimal financial health, as ratios below 1.0 indicate potential cash flow problems while ratios above 2.0 may suggest missed growth opportunities.

• Implement inventory management strategies by balancing stock levels to avoid tying up excess cash while maintaining adequate supply to meet customer demand, and use tracking systems to monitor stock in real time.

• Automate your invoicing and payment processes to improve cash flow by reducing payment delays, following up on overdue accounts, and making it easier for customers to pay you promptly.

What is working capital?

Working capital is the difference between a business's current assets and current liabilities over a 12-month period. This calculation shows whether your business has enough liquid resources to cover short-term obligations.

The result is measured in dollars and can be positive (surplus) or negative (deficit).

Current assets and liabilities

Current assets include anything you can convert to cash within 12 months:

• Cash and bank account funds
• accounts receivable from customers
• Inventory and stock
• Prepaid expenses and short-term investments
• Tax refunds owed to your business

More about current assets

Current liabilities include all debts and obligations due within 12 months:

• Accounts payable to suppliers
• Loan payments and credit interest
• Accrued expenses like wages and fees
• Deferred revenue from customers

More about current liabilities

The importance of working capital in business

Working capital shows your business's financial health and operational strength. It helps you understand three key areas:

• Operational viability: Whether you can cover day-to-day expenses
• Market resilience: Your ability to handle seasonal fluctuations and unexpected changes
• Growth potential: Available funds for reinvestment and expansion

Lenders and investors use working capital to assess your business's financial stability before making funding decisions.

Positive vs negative working capital

Positive working capital occurs when current assets exceed current liabilities. This means your business can pay its bills and has surplus funds for reinvestment.

Negative working capital occurs when current liabilities exceed current assets. This indicates potential cash flow problems and difficulty meeting short-term obligations without additional funding.

Neutral working capital means assets and liabilities are roughly equal. This provides little buffer for unexpected expenses or growth opportunities.

While very low working capital can limit reinvestment, very high working capital may suggest missed opportunities to innovate and grow.

How to calculate working capital

Calculating working capital requires three simple steps:

1. Identify your current assets: Add up all assets convertible to cash within 12 months
2. Calculate your current liabilities: Total all debts due within 12 months
3. Apply the formula: Subtract current liabilities from current assets

If you use accounting software, pull this information directly from your balance sheet and financial reports.

Here's how Xero financial reports can help you.

The working capital formula

A working capital formula example

Working capital calculation example:

A retail florist wants to measure their working capital:

• Current assets: $100,000 (cash, inventory, accounts receivable)
• Current liabilities: $75,000 (supplier payments, loan payments, wages)
• Working capital: $100,000 – $75,000 = $25,000

This positive result means the florist has $25,000 available to cover operations and invest in growth.

Working capital vs working capital ratio

Working capital measures the dollar amount left after subtracting current liabilities from current assets.

Working capital ratio (also called current ratio) measures the relationship between assets and liabilities as a percentage. This ratio shows how many dollars of assets you have for every dollar of liabilities.

Both metrics serve different purposes in assessing your business's financial health. Here's more about the working capital ratio.

Working capital examples in different businesses

Different operating cycles, cash flow patterns, and asset and liability structures mean that a good working capital level varies by industry. For instance, a café might only need 10-15% of working capital per dollar of sales, whereas a heavy machinery manufacturer with slower turnover may require 20-25%. Here's some more detail on the types of working capital in different businesses.

Working capital in construction and manufacturing

Construction projects and manufacturing businesses often have irregular cash flow due to long project timelines and payment schedules. Working capital funds upfront material, subcontractor, and labour costs that the business often can't recover until a project is finished.

For example, a small business manufacturer of building materials wants to know how the business will hold up in an uncertain market.

• They add up their current assets: cash ($100,000) + accounts receivable ($200,000) + inventory ($300,000) = $600,000.
• They add up their current liabilities: accounts payable ($150,000) + short-term loans ($100,000) + accrued expenses ($50,000) = $300,000.
• Applying the working capital formula, they subtract their current liabilities from their current assets: $600,000 – $300,000 = $300,000. The business therefore has $300,000 in positive working capital, so that it has enough assets to cover its liabilities for now.

Working capital in service businesses

Businesses providing services, like consultancies or agencies, don't hold inventory so they typically need less working capital than product-based industries. They may have higher accounts receivable (because they invoice clients) and will still need enough working capital to cover payroll, office expenses, and project costs.

Working capital in retail

Retail and wholesale businesses, and hospitality businesses like food service businesses, often hold lots of inventory and rely on their revenue, so they often need plenty of working capital to buy inventory in advance to meet customer demand in peak seasons. Retail businesses therefore need to balance their stock and sales to keep their working capital healthy.

What is net working capital?

The term 'net working capital' is often used interchangeably with working capital, but there are differences.

• Net working capital (also called operating working capital) excludes cash (an asset) and debt (liabilities) from the calculation. This means you're looking only at the efficiency of the business's daily operations.
• Net working capital is often used for longer-term financial assessments and by businesses that are expanding. It's especially useful in industries like retail, manufacturing, and distribution, where margins are small and your profitability depends on keeping costs down by operating efficiently.

The net working capital formula

Let's look again at the florist. Suppose their current assets include a cash amount of $20,000, and their current liabilities include loan debts of $10,000. The new formula for their net working capital is $80,000 ($100,000 – $20,000) – $65,000 ($75,000 – $10,000) = $15,000.

Working capital vs cash flow: what's the difference?

While working capital shows you how much money is left after you've covered your upcoming costs, cash flow shows how your money moves in and out of your business, and therefore the cash you have on hand.

Here's an example from Xero's short-term cash flow projection. Here, you can see the total money in and out for the next 90 days. It doesn't include liquid assets or show the whole picture of the business's health and adaptability.

How to manage your working capital

Managing working capital directly impacts your business's profitability and cash flow. Effective management ensures you have enough funds for daily operations while maximising growth opportunities.

Manage your inventory

Optimal inventory management involves three key strategies:

• Balance stock levels: Avoid tying up cash in excess inventory while maintaining enough stock to meet demand
• Increase turnover speed: Use promotions and discounts to move slow-selling items quickly, but be aware of the impact on revenue. One business case study found that discounts amounted to 9.4 per cent of total income for the year.
• Implement tracking systems: Use inventory management software to monitor stock in real time and automate reordering. Check out Xero's inventory management guide for more advice and learn more about Xero's inventory management features.

Control your expenses

Cost control strategies help free up working capital:

• Audit expenses: Identify areas to reduce costs without affecting quality or operations by comparing them to an industry benchmark. For example, some sectors aim for salary expenses to be 20-25% of sales, so a business with salary costs at 53.2% of sales would know it has an issue.
• Eliminate waste: Cut non-essential expenses and redirect spending toward growth initiatives
• Streamline processes: Use lean business practices to reduce operational waste. Learn more about tracking business expenses.

Monitor your cash flow

Anticipate shortages or surpluses so you can plan for them by regularly checking your cash inflows and outflows.

Here's more info about forecasting cash flow. Set aside some of your profits as a 'rainy day' fund for lean periods.

Check out Xero's cash flow guide for more advice.

Improve your working capital with Xero

Xero accounting software helps you manage your working capital through tracking your assets and liabilities and streamlining invoicing and payments.

With Xero you can:

• Automate your invoicing and payments
• Track your inventory easily
• Get real-time insights into your finances
• Track your expenses more easily
• Forecast your cash flow

Try Xero for free to get started.

FAQs on working capital

Here are some common questions and answers about working capital.

What is a good working capital ratio for small businesses?

A good working capital ratio for small businesses is typically between 1.2 and 2.0.

• Below 1.0: Insufficient assets to cover debts (requires immediate attention)
• 1.2 to 2.0: Healthy range for most small businesses
• Above 2.0: May indicate excess cash not being used for growth

Industry variations: Service businesses need lower ratios than retailers or manufacturers due to less inventory requirements.

How can I improve working capital ratio?

Here are things you can start doing today to improve your working capital ratio:

• speed up invoicing by sending invoices immediately to reduce the turnaround time of payments – find out how Xero makes invoicing easy
• negotiate better payment terms so your suppliers give you longer to pay and slow your cash outflows
• offer early payment discounts to encourage customers to pay sooner
• control your overheads by cutting non-essential spending to boost your assets

What happens if my working capital ratio is too low?

A low working capital ratio means your business may struggle to cover its short-term debts, so it’s important to address this early to stay solvent.

What is a working capital loan?

If your efforts to improve your working capital ratio have not worked, you may be able to apply for a working capital loan to fund your day-to-day operations. Before taking on new debt it's always a good idea to seek advice from a financial advisor.

Find out more about loans to help manage your working capital.

Is working capital the same as liquidity?

Not quite – your liquidity shows you how easily your business can cover its upcoming costs, while your working capital shows how much money is left after covering those upcoming costs.