Working capital: formula, ratio and how to calculate it

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
• How to manage your working capital
• What is net working capital?
• Working capital vs cash flow: what's the difference?
• 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 understand whether you have enough liquid resources to cover short-term obligations and fund daily operations.
• Monitor your working capital ratio by dividing current assets by current liabilities, aiming for a ratio between 1.2-2.0 for most small businesses to ensure financial stability without tying up too much cash.
• Improve your working capital position by speeding up invoicing, negotiating longer payment terms with suppliers, and managing inventory levels to prevent cash from being tied up in unsold goods.
• Use accounting software to automate invoicing, track expenses in real time, and monitor cash flow patterns to maintain better control over your working capital and spot potential issues before they become problems.

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 resources you have available to cover short-term obligations and fund daily operations.

According to International Financial Reporting Standards (IFRS), this metric helps distinguish the net assets circulating as working capital from those used in long-term operations, providing useful information about your financial health.

Current assets and liabilities

Current assets are resources you can convert to cash within your business's operating cycle. When you can't clearly identify your business's normal operating cycle, assume it's twelve months, which is why this timeframe is commonly used.

• Cash and bank account balances
• Accounts receivable
• Inventory
• Prepaid expenses
• Short-term investments
• Tax refunds (when expected within 12 months)

Current liabilities are generally obligations you must pay within 12 months. However, some items like trade payables and accruals are classified as current liabilities because they are part of working capital used in the normal operating cycle, even if they're due to be settled more than twelve months later.

• Accounts payable
• Loan and credit payments
• Deferred revenue
• Accrued expenses like wages and bank fees

How to calculate working capital

Calculate working capital by subtracting your current liabilities from your current assets. You'll need figures for both over 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

A working capital formula example

Here's how a retail florist calculates their working capital:

1. Add up current assets: Cash, inventory, and receivables total $100,000 over the next 12 months.
2. Add up current liabilities: Payables, loans, and expenses total $75,000 over the next 12 months.
3. Apply the formula: $100,000 − $75,000 = $25,000 in positive working capital.

This florist has enough assets to cover their liabilities, with $25,000 available for operations or reinvestment.

Working capital vs working capital ratio

Working capital tells you the dollar amount left after subtracting liabilities from assets. Working capital ratio (also called the current ratio) shows the relationship between them as a ratio.

The formula is: current assets ÷ current liabilities = working capital ratio

For example, $100,000 in assets ÷ $75,000 in liabilities = 1.33 ratio. A ratio above 1.0 means you have more assets than liabilities.

The importance of working capital in business

Working capital matters because it reveals whether your business can pay its bills, survive slow periods, and invest in growth.

Here's why it's worth tracking:

• Operational health: shows if you can cover day-to-day expenses
• Resilience: indicates your ability to handle market or seasonal fluctuations
• Growth potential: reveals whether you have surplus funds to reinvest
• Credibility: lenders and investors use it to assess your financial stability

Positive vs negative working capital

Positive working capital means your current assets exceed your current liabilities. You can pay your bills and debts, with surplus funds available to reinvest in growth.

Negative working capital means your current liabilities exceed your current assets. You'll need to secure additional funding or improve cash flow to meet short-term obligations. Addressing this promptly helps maintain your business's financial health.

Neutral working capital means your assets and liabilities are roughly equal. This works if you're consistently converting inventory into cash, but it leaves little buffer for unexpected expenses or reinvestment.

Too much working capital signals an opportunity to reinvest in innovation or growth. While it sounds positive, excess working capital may mean you're not maximizing your resources.

Working capital examples in different businesses

Working capital needs vary by industry. Different operating cycles, cash flow patterns, and asset structures mean a "healthy" figure for one business may not work for another.

Working capital in construction and manufacturing

Construction and manufacturing businesses typically need more working capital because of irregular cash flow. Long project timelines mean you pay for materials, subcontractors, and labour upfront but may not recover those costs until the project is complete.

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

1. They add up their current assets: cash ($100,000) + accounts receivable ($200,000) + inventory ($300,000) = $600,000.
2. They add up their current liabilities: accounts payable ($150,000) + short-term loans ($100,000) + accrued expenses ($50,000) = $300,000.
3. They apply the working capital formula by subtracting their current liabilities from their current assets: $600,000 – $300,000 = $300,000. The business has $300,000 in positive working capital, with enough assets to cover its liabilities.

Working capital in service businesses

Service businesses typically need less working capital than product-based businesses because they don't hold inventory. However, they often have higher accounts receivable from client invoicing.

Key working capital needs for service businesses:

• Payroll and contractor payments
• Office and operating expenses
• Project-related costs

Working capital in retail

Retail, wholesale, and hospitality businesses often need substantial working capital because they hold significant inventory. You need cash to buy stock in advance, especially before peak seasons.

Balancing inventory levels with sales is critical. Too much stock ties up cash; too little means missed sales opportunities.

How to manage your working capital

Effective working capital management helps you maintain enough liquidity to cover expenses, avoid cash shortfalls, and free up funds for growth. These strategies help you optimize your working capital and strengthen your financial position.

Manage your inventory

Keeping inventory at the right level prevents cash from being tied up in unsold goods while ensuring you can meet demand.

Here's how to optimise your inventory:

• maintain stock levels that balance cash flow with customer demand
• offer promotions or discounts to move slow-selling items faster
• use inventory management software to track stock, forecast demand, and automate reordering

Control your expenses

Reducing unnecessary costs frees up cash for operations and growth.

Here's how to control expenses effectively:

• identify areas to cut costs without affecting quality or operations
• eliminate non-essential spending and prioritise growth-focused investments
• adopt lean practices to streamline processes and reduce waste

Monitor your cash flow

Regular cash flow monitoring helps you spot potential shortages before they become problems.

Here's how to stay on top of your cash flow:

• review cash inflows and outflows regularly to anticipate surpluses or shortfalls
• set aside a portion of profits as a reserve for lean periods
• use cash flow forecasting tools to plan ahead

Invest in software tools to streamline your operations

Accounting software like Xero helps you manage working capital by automating routine tasks and providing real-time financial visibility.

Key benefits for working capital management:

• Automated invoicing: generate and send invoices automatically, track payment status, and follow up on overdue accounts to reduce payment delays
• Payment management: send automatic reminders and offer multiple payment options to help customers pay faster
• Expense tracking: monitor costs in real time to maintain control over cash outflows
• Anywhere access: manage your finances from any device with an internet connection, so you can respond to cash flow issues as they arise

These features give you greater control over your finances, helping you maintain healthy working capital and grow with confidence.

What is net working capital?

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

The formula is: (current assets − cash) − (current liabilities − debt) = net working capital

Net working capital is useful when:

• assessing long-term financial health
• evaluating operational efficiency during expansion
• analysing businesses with thin margins, like retail, manufacturing, or distribution

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?

Working capital shows the excess of current assets over current liabilities, indicating short-term liquidity rather than cash left over.

Cash flow tracks how money moves in and out of your business over time. It shows the actual cash you have available right now.

The key difference: working capital includes liquid assets like inventory and receivables, while cash flow focuses specifically on cash movement.

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.

Improve your working capital with Xero

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

With Xero, you can:

• automate invoicing and payment collection
• track inventory levels in real time
• access real-time insights into your financial position
• monitor and categorise expenses easily
• forecast cash flow to plan ahead

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 and how it affects your business.

What is a good working capital ratio for small businesses?

A good working capital ratio for most small businesses is 1.2–2.0. A ratio below 1.0 means you may not have enough assets to cover your short-term debts.

This 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:

1. Speed up invoicing: send invoices immediately to reduce payment turnaround time.
2. Negotiate payment terms: ask suppliers for longer terms to slow cash outflows.
3. Offer early payment discounts: encourage customers to pay sooner with small incentives.
4. Cut non-essential spending: reduce overheads to free up cash and boost your asset position.

What happens if my working capital ratio is too low?

A low working capital ratio means your business needs more liquid assets to comfortably cover short-term debts. Addressing this promptly helps protect your business's financial stability.

If your ratio is low, focus on speeding up receivables, reducing inventory, or negotiating longer payment terms with suppliers.

What is a working capital loan?

A working capital loan is a short-term loan used to fund day-to-day business operations when you need additional liquidity. Consider it after exploring other strategies, like improving receivables or reducing costs.

Before taking on new debt, consult a financial advisor to explore all your options.

Is working capital the same as liquidity?

Not exactly. Liquidity measures how easily you can convert assets to cash to cover upcoming costs. Working capital shows the dollar amount remaining after you've accounted for those costs.

Both indicate short-term financial health, but liquidity focuses on ease of access while working capital focuses on the surplus or deficit.