Working capital: what it is, formula and why it matters

Published Monday 30 March 2026

Table of contents

• What is working capital?
• How to calculate working capital
• The importance of working capital in business
• 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 enough liquid resources to cover short-term expenses and fund growth opportunities.
• Maintain a working capital ratio between 1.2 and 2.0 for optimal financial health, as ratios below 1.0 indicate insufficient assets to cover debts while extremely high ratios suggest missed growth opportunities.
• Speed up cash collection by automating invoicing, offering early payment discounts to customers, and using accounting software to track payment status and follow up on overdue accounts.
• Optimise inventory levels to free up cash by turning over stock faster through promotions on slow-moving items and using inventory software to forecast demand and automate reordering.

What is working capital?

Working capital is the difference between your business's current assets and current liabilities. It shows how much cash and liquid assets you have available to cover short-term expenses and invest in growth.

Current assets and liabilities

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

• cash and bank account balances
• accounts receivable
• inventory
• prepaid expenses
• short-term investments
• tax refunds

Current liabilities include any debts due within 12 months:

• accounts payable
• loan repayments and interest
• deferred revenue
• accrued expenses like wages and bank fees

How to calculate working capital

To calculate working capital, subtract your current liabilities from your current assets. You'll need to project both figures for the next 12 months.

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

The working capital formula

Here's the formula for calculating working capital:

A working capital formula example

Here's how a retail florist might calculate their working capital:

1. Add up current assets for the next 12 months: $100,000
2. Add up current liabilities for the next 12 months: $75,000
3. Subtract liabilities from assets: $100,000 – $75,000 = $25,000 in positive working capital

This means the florist has enough liquid assets to cover upcoming expenses and some surplus to reinvest.

Working capital vs working capital ratio

Working capital tells you the dollar amount left after covering liabilities. Working capital ratio (also called current ratio) shows the relationship between assets and liabilities as a number.

For example, if you have $100,000 in assets and $75,000 in liabilities:

• Working capital: $25,000
• Working capital ratio: 1.33 ($100,000 ÷ $75,000)

Both metrics assess short-term financial health, but they answer different questions.

The importance of working capital in business

Working capital matters because it shows whether your business can pay its bills and fund day-to-day operations. Here's why it's important:

• Operational health: reveals if you can cover short-term expenses
• Financial resilience: shows your ability to handle seasonal slowdowns or market shifts. Poor working capital can have serious consequences; in one survey of over 21,000 failed businesses, 70% reported they had run out of money and lost their ability to pay.
• Growth potential: indicates whether you have funds to reinvest in the business
• Credibility: lenders and investors use working capital to assess your financial stability

Positive vs negative working capital

• Positive working capital: Your current assets exceed your current liabilities. You can pay your bills, cover debts, and reinvest surplus funds into the business.
• Negative working capital: Your current liabilities exceed your current assets. You may need to borrow or raise funds to meet debts. If this continues, take action to restore financial stability.
• Neutral working capital: Your assets and liabilities are roughly equal. This works if sales are steady, but leaves little buffer for unexpected expenses or reinvestment.

Very high working capital isn't always ideal either, as it may suggest you're not investing enough in growth or innovation. Research confirms that there's a sweet spot for working capital – both too little and too much can hurt financial performance.

Working capital examples in different businesses

A "good" working capital figure varies by industry. Different businesses have different operating cycles, cash flow patterns, and asset structures. Here's how working capital applies across common business types.

Working capital in construction and manufacturing

Construction and manufacturing businesses often face irregular cash flow due to long project timelines. Working capital covers upfront costs for materials, subcontractors, and labour before payments come in.

Here's an example for a building materials manufacturer:

1. Current assets: cash ($100,000) + accounts receivable ($200,000) + inventory ($300,000) = $600,000
2. Current liabilities: accounts payable ($150,000) + short-term loans ($100,000) + accrued expenses ($50,000) = $300,000
3. Working capital: $600,000 – $300,000 = $300,000 positive

This manufacturer has enough assets to cover liabilities and weather market uncertainty.

Working capital in service businesses

Service businesses like consultancies and agencies typically need less working capital than product-based industries because they don't hold inventory.

However, service businesses still need working capital to cover:

• payroll costs
• office expenses
• project-related costs
• gaps between invoicing and receiving payment

Higher accounts receivable is common in service industries, so managing payment timing is key.

Working capital in retail

Retail and wholesale businesses typically need more working capital because they hold significant inventory. They must buy stock in advance to meet customer demand, especially during peak seasons.

Healthy working capital in retail depends on balancing stock levels with sales. Too much inventory ties up cash; too little risks lost sales.

What is net working capital?

Net working capital (also called operating working capital) is a variation that excludes cash and debt from the calculation. It focuses purely on the efficiency of your daily operations.

Use net working capital when you want to:

• assess long-term operational efficiency
• evaluate a business during expansion
• analyse industries with thin margins, like retail, manufacturing, or distribution

The formula excludes cash from assets and debt from liabilities, giving you a clearer picture of operational performance.

The net working capital formula

Here's how to calculate net working capital:

Using the florist example, here's how to calculate net working capital:

1. Current assets excluding cash: $100,000 – $20,000 = $80,000
2. Current liabilities excluding debt: $75,000 – $10,000 = $65,000
3. Net working capital: $80,000 – $65,000 = $15,000

This figure shows the florist's operational efficiency without factoring in cash reserves or loan obligations.

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

Working capital and cash flow measure different things:

• Working capital: the amount left after covering upcoming costs (assets minus liabilities)
• Cash flow: how money moves in and out of your business over time

Cash flow shows your available cash at any moment. Working capital shows your overall short-term financial position, including liquid assets like inventory and receivables.

Xero's cash flow projection (shown below) tracks money in and out over 90 days. It complements working capital by showing timing of payments, but doesn't capture your full financial health.

How to manage your working capital

Managing working capital keeps your business financially stable and ready for growth. Here are practical steps to improve your working capital position.

Manage your inventory

• Keep inventory at optimal levels: avoid tying up cash in unsold goods or running too low to meet demand
• Turn over stock faster: offer promotions or discounts on slow-moving items. This is critical because research shows that holding inventory for too long can have negative and statistically significant impacts on a company's return on assets.
• Use inventory software: track stock in real time, forecast demand, and automate reordering

Control your expenses

• Identify cost-cutting opportunities: find areas to reduce spending without affecting quality
• Cut non-essential expenses: focus spending on activities that drive growth
• Streamline processes: use lean practices to reduce waste and improve efficiency

Monitor your cash flow

Stay ahead of cash flow issues by monitoring your finances regularly:

• Review inflows and outflows: check cash movement regularly to anticipate shortages or surpluses
• Build a reserve fund: set aside profits for lean periods or unexpected expenses

Invest in software tools to streamline your operations

Accounting software like Xero helps you manage working capital by streamlining key financial tasks:

• Automate invoicing: generate and send invoices automatically, track payment status, and follow up on overdue accounts to reduce payment delays
• Manage customer payments: send automatic reminders and offer multiple payment options to speed up collections
• Track expenses in real time: monitor spending as it happens to control costs and spot issues early
• Access finances anywhere: use cloud-based software to check your financial data and respond to cash flow issues from any location

These features give you more control over your finances, helping you maintain healthy working capital and support business growth.

Improve your working capital with Xero

Xero accounting software helps you manage working capital by tracking assets and liabilities, streamlining invoicing, and giving you real-time financial insights.

With Xero you can:

• automate invoicing and payments
• track inventory in real time
• monitor expenses as they happen
• forecast your cash flow
• access your finances from anywhere

Ready to take control of your working capital? Get one month free and see how Xero can help your business.

FAQs on working capital

Here are answers to common questions 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. This aligns with research where a study of over 20,000 firms found that a majority (66.6%) maintained a large average ratio. A ratio below 1.0 means you don't have enough assets to cover your debts.

Ideal ratios vary by industry. Service businesses generally need lower ratios than retailers managing significant inventory.

How can I improve working capital ratio?

Here are steps you can take today to improve your working capital ratio:

1. Speed up invoicing: send invoices immediately to reduce payment turnaround time
2. Negotiate longer payment terms: ask suppliers for extended deadlines to slow cash outflows, while being mindful of the trade-offs. While this can preserve cash, some research suggests that delaying payments to suppliers can ultimately reduce business profitability.
3. Offer early payment discounts: encourage customers to pay sooner
4. Control overheads: cut non-essential spending to preserve more assets

What happens if my working capital ratio is too low?

A low working capital ratio means your business may struggle to cover short-term debts. If this continues, take steps to improve your financial position. Take action early by improving collections, reducing expenses, or negotiating better payment terms with suppliers.

What is a working capital loan?

A working capital loan is a short-term loan that funds day-to-day operations when your business needs extra cash flow support. Consider this option after exploring other ways to improve working capital.

Before taking on new debt, seek advice from a financial advisor to understand the impact on your business.

Is working capital the same as liquidity?

Not quite. Liquidity measures how easily you can access cash to cover upcoming costs. Working capital measures how much is left after you've accounted for those costs.

Both relate to short-term financial health, but liquidity focuses on cash availability while working capital shows your overall position.