What is working capital? Formula and why it matters

Published Thursday 2 April 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 regularly by subtracting current liabilities from current assets to determine if you have enough short-term resources to cover upcoming expenses and keep your business operating smoothly.
• Monitor your working capital position closely since positive working capital means you can pay bills and invest in growth, while negative working capital signals potential cash flow problems that need immediate attention.
• Improve your working capital by speeding up invoice collection, optimising inventory levels to free up tied-up cash, and negotiating better payment terms with suppliers to slow cash outflows.
• Use accounting software to automate invoicing, track expenses in real time, and generate financial reports that give you instant visibility into your working capital position for better decision-making.

What is working capital?

Working capital is the difference between your business's current assets and current liabilities. It shows whether you have enough short-term resources to cover upcoming expenses and keep operating. The result is measured in dollars as either a surplus or deficit.

Current assets and liabilities

Current assets are resources you can convert to cash within 12 months:

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

More about current assets

Current liabilities are obligations you must pay within 12 months:

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

More about current liabilities

How to calculate working capital

Calculating working capital tells you whether your business has enough resources to cover short-term obligations. The formula is straightforward: subtract your current liabilities from your current assets.

You'll need to project both figures for the next 12 months. Accounting software like Xero makes this easy by pulling the numbers 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

The owner of a retail florist business needs to measure their working capital.

First, they add up their current assets across the next 12 months. The total comes to $100,000.

They then total their current liabilities across the next 12 months, which come to $75,000.

Using this information, they calculate their working capital is $25,000 ($100,000 – $75,000).

Working capital vs working capital ratio

Working capital and working capital ratio measure the same components but answer different questions:

• Working capital: Subtracts liabilities from assets to show a dollar amount. Use this to see how much surplus or shortfall you have.
• Working capital ratio: Divides assets by liabilities to show a ratio. Use this to compare your position against industry benchmarks or track trends over time.

Here's more about the working capital ratio.

The importance of working capital in business

Understanding your working capital helps you make smarter decisions about growth, expenses, and day-to-day operations. In fact, a 2024 Visa report found that top-performing companies achieved significant bottom-line benefits (averaging $11 million) from effective working capital management.

Working capital matters because it reveals whether your business can pay its bills, handle unexpected costs, and invest in growth. Here's why it's important:

• Operational health: Shows if you can cover day-to-day expenses
• Financial resilience: Indicates your ability to handle market shifts or slow seasons
• Growth potential: Reveals whether you have surplus funds to reinvest
• Credibility: Lenders and investors use working capital to assess your financial stability

Positive vs negative working capital

Your working capital result tells you where your business stands financially:

• Positive working capital: Your current assets exceed your liabilities. You can pay your bills, cover debts, and reinvest surplus funds into growth.
• Negative working capital: Your liabilities exceed your assets. You may struggle to meet obligations without borrowing or raising funds. Ongoing negative working capital signals financial trouble; one study found that 49% of bottom-performing companies had unpredictable financing needs in the past year, compared to just 1.2% of top performers.
• Neutral working capital: Assets and liabilities are roughly equal. This works if you're converting inventory to cash quickly, but leaves little buffer for surprises or reinvestment.

Keep in mind that very high working capital isn't always ideal either. It may suggest you're holding too much cash instead of investing in innovation or growth.

Working capital examples in different businesses

A "good" working capital figure varies by industry. Operating cycles, cash flow patterns, and asset structures all affect what's healthy for your business type.

Working capital in construction and manufacturing

Construction and manufacturing businesses typically need higher working capital because of irregular cash flow.

Long project timelines mean you pay for materials, subcontractors, and labour upfront. You often can't recover these costs until the project is complete, which can take months.

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

Service businesses like consultancies and agencies typically need less working capital because they don't hold inventory.

However, they often carry higher accounts receivable from client invoicing. You'll still need enough working capital to cover payroll, office expenses, and project costs between payments.

Working capital in retail

Retail, wholesale, and hospitality businesses often need substantial working capital because they hold significant inventory.

You'll typically buy stock in advance to meet peak-season demand, which ties up cash before you generate sales. Balancing inventory levels with expected revenue keeps your working capital healthy.

What is net working capital?

Net working capital (also called operating working capital) measures your operational efficiency by excluding cash and debt from the standard working capital formula.

Here's how it differs from working capital:

• Standard working capital: Includes all current assets and liabilities
• Net working capital: Excludes cash from assets and debt from liabilities

Net working capital is especially useful for:

• longer-term financial assessments
• businesses planning expansion
• industries with tight margins like retail, manufacturing, and distribution

Here's how to calculate net working capital.

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 both metrics help you understand your business's financial health, working capital and cash flow measure different things.

Working capital and cash flow both measure financial health, but they answer different questions:

• Working capital: Shows how much money remains after covering upcoming costs. It's a snapshot of your short-term financial position.
• Cash flow: Tracks how money moves in and out of your business over time. It shows the cash you have available right now.

Here's an example from Xero's short-term cash flow projection. Here, we see figures for 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 your working capital keeps your business financially stable and ready for growth. Effective management means optimising your assets, controlling expenses, and maintaining visibility into your cash position. In response to economic pressures like inflation and supply chain disruptions, organisations are emphasising working capital management to build financial resilience.

Here are practical ways to improve your working capital.

Manage your inventory

Effective inventory management frees up cash without leaving you short on stock:

• Optimise stock levels: Hold enough inventory to meet demand without tying up excess cash in unsold goods
• Accelerate turnover: Use promotions or discounts to move slow-selling items faster
• Automate tracking: Use inventory management software to monitor stock in real time, forecast demand, and trigger reorders automatically

Check out Xero's inventory management guide for more advice and learn more about Xero's inventory management features.

Control your expenses

Reducing unnecessary expenses improves your working capital position:

• Review spending: Identify cost reductions that won't affect quality or operations
• Prioritise growth: Cut non-essential expenses and redirect funds toward business development
• Streamline processes: Apply lean practices to reduce waste and improve efficiency

Learn more about tracking business expenses.

Monitor your cash flow

Regular cash flow monitoring helps you spot problems early and plan ahead:

• Track movement: Check your cash inflows and outflows regularly to anticipate shortages or surpluses
• Build reserves: Set aside a portion of profits as a buffer for slow periods or unexpected expenses

Invest in software tools to streamline your operations

Accounting software like Xero helps you manage working capital by automating routine tasks and improving visibility:

• Automate invoicing: Generate and send invoices automatically, track payment status, and follow up on overdue accounts without manual effort
• Speed up payments: Send automatic reminders and offer multiple payment options to reduce delays
• Track expenses: Monitor spending in real time to control costs and spot issues early
• Access anywhere: Manage your finances from any device with cloud-based software, so you can respond to cash flow issues as they arise

These features give you more control over your financial position, helping you improve working capital and grow with confidence.

Here's how Xero can help you manage your working capital

Improve your working capital with Xero

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

With Xero you can:

• automate invoicing and payment collection
• track inventory levels in real time
• access instant insights into your financial position
• monitor expenses as they happen
• forecast your cash flow with confidence

Ready to take control of your working capital? Get one month free and see how Xero simplifies financial management for small businesses.

Here's more about how Xero can help your business.

FAQs on working capital

Here are answers to common questions about working capital and how it affects your business.

What is working capital in simple terms?

Working capital is the money your business has available to pay its bills over the next 12 months. Calculate it by subtracting what you owe from what you own. A positive number means you can cover your short-term expenses.

What is a good working capital ratio for small businesses?

A good working capital ratio for most small businesses is between 1.2 and 2.0. A ratio below 1.0 means you don't have enough assets to cover your debts.

The ideal ratio varies by industry. Service businesses typically 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:

• Speed up invoicing: Send invoices immediately to reduce payment turnaround time. This aligns with a growing trend where, in 2024, growth companies paid 37% of their invoices early, a significant increase from the previous year.
• Negotiate payment terms: Ask suppliers for longer payment windows to slow cash outflows
• Offer early payment discounts: Encourage customers to pay sooner with small incentives
• Control overheads: Cut non-essential spending to increase your available assets

What happens if my working capital ratio is too low?

A low working capital ratio indicates your business needs more resources to cover short-term debts. If this continues, it could lead to insolvency. Address the issue quickly by speeding up receivables, reducing expenses, or securing short-term financing.

What is a working capital loan?

A working capital loan is short-term financing used to cover day-to-day operating expenses when cash flow is tight. The use of such tools is becoming more common, with a recent survey showing that more than 8 in 10 CFOs and treasurers used working capital solutions in the past year. Consider this option after exploring other improvement strategies. Before taking on new debt, consult a financial advisor to explore all your options.

Is working capital the same as liquidity?

Not quite. They measure related but different things:

• Liquidity: Shows how easily you can convert assets to cash to cover upcoming costs
• Working capital: Shows how much money remains after covering those costs

Both help assess short-term financial health, but working capital gives you a specific dollar figure while liquidity focuses on your ability to access funds quickly.