Working capital: calculation, formula and benchmarks

Working capital: calculation, formula and benchmarks

Working capital is calculated by subtracting current liabilities from current assets. It shows how much cash is tied up in day-to-day operations and whether a company can meet its short-term obligations without additional financing.

For controllers and CFOs in mid-sized companies, working capital is the hinge between profit and cash: a profitable business can still run into liquidity problems when inventory and receivables absorb too much money.

What is working capital?

Working capital is the difference between assets that convert into cash within a year and liabilities that fall due within a year. Two definitions are commonly used:

• Net working capital: all current assets minus all current liabilities, including cash and short-term bank debt. This is the broad, balance-sheet definition.
• Operating working capital: inventory plus receivables minus payables. This definition excludes cash and financing and therefore measures purely how much money the operation itself locks up.

For management information the operating variant is usually the most useful: those items are directly influenced by purchasing, sales and credit control.

The working capital formula

Net working capital = current assets − current liabilities

Operating working capital = inventory + receivables − payables

1. Add up current assets: inventory, trade receivables, other receivables and cash.
2. Add up current liabilities: trade payables, tax and payroll liabilities, overdraft facilities and other obligations due within a year.
3. Subtract current liabilities from current assets.
4. Also calculate operating working capital, so you can see how much is tied up in the operation itself.

The result is an amount, not a ratio. To express the same items as a factor, use the current ratio: current assets divided by current liabilities.

Worked example: working capital calculation

Balance sheet item	Amount
Inventory	€300,000
Trade receivables	€450,000
Cash	€150,000
Current assets	€900,000
Trade payables	€400,000
Other current liabilities	€200,000
Current liabilities	€600,000
Net working capital	€300,000
Operating working capital	€350,000

Net working capital = 900,000 − 600,000 = €300,000. Operating working capital = 300,000 + 450,000 − 400,000 = €350,000. The operating figure is higher here because cash and other current liabilities are excluded.

What is a healthy level of working capital?

There is no universal benchmark. The amount required depends on the business model: a supermarket sells inventory within days and buys on credit, so it structurally operates with negative working capital — perfectly healthy. A machine builder with long lead times that pre-finances materials needs substantial positive working capital.

• Too low: not enough buffer to pay suppliers, payroll taxes and VAT on time. Any delay on the customer side immediately becomes a cash problem.
• Too high: capital sits idle in inventory and receivables, which depresses the return on capital — see return on equity and assets.

Always assess working capital as a percentage of revenue, as a trend over several months and against the industry norm. Combine it with the solvency ratio for the longer-term picture.

Working capital requirement and the cash conversion cycle

The working capital requirement is driven by the time between paying and getting paid. That time is measured with the cash conversion cycle (CCC), built from three durations in days:

• DSO (days sales outstanding): the average number of days customers take to pay.
• DIO (days inventory outstanding): the average number of days inventory stays on the balance sheet.
• DPO (days payables outstanding): the average number of days before you pay suppliers.

CCC = DSO + DIO − DPO

With DSO 45, DIO 60 and DPO 30, the CCC is 75 days: the company self-finances roughly two and a half months of revenue. Every day removed from the CCC is released as cash. At €12 million revenue, one day is about €33,000.

How to improve working capital

• Credit control: invoice immediately after delivery, work with a fixed aging analysis and run a structured dunning process. A falling DSO is the quickest win.
• Inventory management: analyse turnover per product group, clear slow-moving items and align purchasing with current demand rather than historical ordering patterns.
• Supplier payment terms: negotiate realistic terms and use them fully, but weigh early-payment discounts against the interest cost of credit.
• Prepayments and milestone billing: on long projects this shifts the financing burden to the customer.

Monitoring working capital in practice

Working capital changes daily, yet in many organisations it is only calculated at year-end. Smartbooks derives net and operating working capital, DSO, DIO and DPO directly from the ledgers and shows receivables and payables aging per entity and consolidated. That puts the working capital figures in the same reporting set as the result, connected to the 13-week cash flow plan.

Frequently asked questions about working capital

How do you calculate working capital?
Subtract current liabilities from current assets. For operating working capital, take inventory plus receivables minus payables.

What is the difference between working capital and the current ratio?
Working capital is an amount (a difference), the current ratio is a factor (a proportion). Both use the same balance sheet items.

Is negative working capital always bad?
No. In retail and hospitality negative working capital is normal, because customers pay immediately and purchasing happens on credit. With long lead times it is a warning signal.

How much working capital do I need?
That follows from the cash conversion cycle: the longer the gap between paying and being paid, the more working capital is needed to finance revenue.

Working capital in your reporting, automatically

In Smartbooks, working capital, aging and liquidity ratios are part of your monthly reporting by default — per entity and consolidated, without Excel work. Book a demo and see it on your own numbers.