What is working capital? The answer you’ll get depends on who you ask.
An accountant will give you a formula, while a small business owner who’s been through cash flow difficulties will tell you it’s the difference between their business sinking or swimming.
A lack of working capital is one of the most common reasons South Africa’s small- and medium-sized enterprises (SMEs) fail, but many business owners are not sure what it is exactly or how it can be the earliest warning system a business has.
This article breaks down what working capital is in plain English, including how to calculate it and why it’s so important for small businesses.
– What is Working Capital in Simple Terms?
– The Working Capital Formula (And How to Use It)
– What the Working Capital Ratio Tells You
– Positive vs. Negative Working Capital: What Each Means for Your SME
– The Working Capital Cycle: Why Timing Is Everything
– What Is Working Capital Finance – And When Does an SME Need It?
What is Working Capital in Simple Terms?
Working capital is the money your business is left with once you deduct what your business owes (current liabilities) from what your business owns (current assets).
This figure is a measure of how easily your business can meet its short-term obligations (rent, overheads, staff wages) without struggling. Your accountant probably refers to it as liquidity.
A smooth flow of working capital, and thus strong liquidity, is a key metric when assessing the health of your business. Not only does it mean that you have a buffer to protect yourself against unexpected expenses, but you also have the freedom to take advantage of new opportunities, which typically require an injection of capital.
It’s worth clearing up one common confusion early: working capital is not the same as profit.
Profit is what your business has earned over a period; working capital is what you can actually access right now. A business can be profitable and still unable to pay its bills if that profit is tied up in unpaid invoices or stock.
“Owners track profit and ignore the gap between getting paid and paying out,” says Lee McCabe, Partner at Claymore Partners, a US equity advisory firm.”You can be profitable on paper and insolvent in practice if your customers pay in 90 days and your suppliers want 30.”
To put it simply, keeping an eye on your working capital, rather than your profit alone, is what tells you whether you can cover what’s actually due right now.
There’s one more term worth clearing up while we’re here, because it trips up a lot of business owners: net working capital.
What is net working capital – is it different?
In most cases, the net working capital meaning is the same as working capital: it’s simply current assets minus current liabilities.
Some financial professionals strip this down, however, to make net working capital a narrower concept. Here, they remove items like cash equivalents or short-term debts to focus on day-to-day operational items only. This is known as the adjusted net working capital.
Generally speaking, though, the first two terms are interchangeable. If someone asks about your net working capital, they normally mean your normal working capital figure.
The Working Capital Formula (And How to Use It)
Working Capital Definition = Total Current Assets − Current Liabilities
The formula is simple and extremely powerful. It lets you see exactly the funds you have to power your business over the next 12 months.
However, it may not be clear which items fall into which category, so here’s a quick run-through.
Current assets
These are all either cash or items you can turn into cash within a year.
– The cash in your bank accounts
– Accounts receivable (the money your customers owe you)
– Your current stock of finished goods
– Inventory of raw materials
– Any short-term investments or prepaid expenses (ie insurance paid in advance)
Current liabilities
These are all typically expenses due within one year.
– Accounts payable (what you owe your suppliers)
– Short-term loans
– Accrued expenses like salaries and VAT
– Any overdraft balance
As a rule of thumb, an excellent working capital figure is enough to cover expenses for the next three to six months. Anything less than this, and your business may be caught off-guard by an unexpected expense or slow trading period.
“An SME may not need a long-term loan,” says Dylan Weimann, Head of Credit Underwriting at Lula. “They may just need short-term liquidity to buy stock, pay a supplier or bridge a payment cycle.”
Let’s take a look at what this might look like for a South African small business.
An SME working capital example
Wendy Schmitz, a Cape Town retailer, reads up on how to calculate working capital and decides to do the sums. She finds that she holds R40,000 in cash, and her customers owe her R20,000. She also holds R80,000 in stock.
Her total current assets are R140,000 (40+20+80).
She owes R60,000 to suppliers and recently took out a short-term loan of R30,000.
Her total current liabilities are R90,000 (60+30)
This gives her R50,000 in working capital (140-90).
What the Working Capital Ratio Tells You
Knowing the amount of your working capital is one thing, but if you’d like to know how healthy it is compared to your obligations, then the working capital ratio is the key.
The formula is:
Working Capital Ratio = Total Current Assets ÷ Current Liabilities
If we put Wendy’s numbers into this, we get the following:
R140,000 divided by R90,000 equals roughly 1.6.
So what does this mean? Well, financial experts consider a ratio below 1 to be a warning sign because it means your short-term liabilities outweigh your assets.
Anything up to 1.5 is slightly risky, with between 1.5 and 2 being that ‘Goldilocks’ area of ‘just right’.
Much higher than 2, and you may be sitting on idle cash or stock that could be working harder for you.
Wendy, then, has the ideal working capital ratio for a retailer. Someone in her field carrying substantial inventory would expect a higher ratio, since so much of their cash is tied up in stock, but this could be different for a service business, which holds almost no inventory and may run comfortably on a leaner ratio.
As a single metric for short-term financial health, the ratio is probably the most useful you can track.
Positive vs. Negative Working Capital: What Each Means for Your SME
Beyond the obvious narrative of positive working capital being good for your business and negative working capital being bad, there are a few nuances worth knowing.
A few businesses deliberately run on negative working capital because they collect cash from customers before their suppliers’ bills fall due. Supermarkets are a great example: shoppers pay on the spot, but they pay suppliers later, so the business effectively runs on its suppliers’ money.
That said, negative capital is something to rectify rather than build a business model around. If your business is continually leaning on its overdraft, chasing debtors or timing supplier payments around the next big invoice, then it’s time to take action.
The rewards of turning it around can be impressive. Positive working capital means a healthy cash flow and the breathing room to run your business on the front foot. That means covering the unexpected,and freeing cash to invest when the right opportunity appears.
“Cash flow is the most important ingredient in a business and impacts everything you do,” says Willem Harov, owner of DoughGetters Accounting, a local financial firm.
The working capital you have dictates your cash flow and whether you can make payroll this week or whether you can take on that bigger order next month. In other words, it can be the lever that drives growth.
Yet timing is just as important. A business can look healthy on paper and still come up short at the exact moment the money is needed.
To understand why, you need to look at how cash actually moves through your business.
The Working Capital Cycle: Why Timing Is Everything
The working capital cycle, sometimes called the cash conversion cycle, is the engine behind your business’s cash flow.
We can measure it as the number of days it takes for you to turn your resources back into cash. That is, from buying the stock or materials, selling them, and then receiving payment.
The longer this cycle is, the more cash is tied up in your business and out of your reach. You might be doing well on paper, but an unnecessarily long working capital cycle can eventually run you dry.
A construction firm, for example, can be waiting 60 days for a big building project payment but be unable to pay its builders each Friday.
The shorter your cycle, the healthier your cash flow management tends to be. A tight working capital cycle doesn’t just keep you safe; it lets you grow faster.
You can tighten this by doing several or all of the following:
- Invoicing for a job or sale the moment it’s done
- Quickly follow up on overdue accounts
- Offer small early payment incentives
- Negotiating sensible payment terms with both customers and suppliers
- Finding flexible and affordable funding options to cover cash flow gaps
Funding is a particularly effective way of reducing this cycle if used correctly.
“You receive the stock, and it needs to be paid for at the end of the month, but it hasn’t yet had the cycle to generate the cash to settle the bill, says Dave Hutcherson of clothing retailer Sexy Socks. “A bridging facility that tides you over until your cash flow cycle catches up with your business needs can be fast, efficient and reliable.”
What Is Working Capital Finance – And When Does an SME Need It?
Running into cash flow gaps is part of life for any South African business because working capital cycles don’t tend to line up neatly with the calendar. There are also unexpected events that throw a spanner in the works, like a reliable client who pays 60 days late, or a prolonged power outage that stops operations.
For this, the right type of working capital finance can be the engine that keeps your business running and growing. A flexible line of business funding, like Lula’s Cash Flow Facility, is one example. After a quick and simple application, your business can access funds within as little as 24 hours, with:
- Up to R5 million in working capital to cover the gap until your revenue catches up – or seize new opportunities
- A transparent fee on what you use, instead of interest or admin fees
- The option to redraw funds following repayment, subject to affordability.
For a defined, once-off need, Lula’s Fixed-Term Funding offers a lump sum repaid over three, six, nine or 12 months with fixed fees and no early repayment penalties.
To qualify, you need at least one consecutive year of trading history as a registered South African business, monthly revenue of R40,000 or more and a credit score in good standing. Lula reviews your bank statements and credit score as part of the assessment, and once approved, we disburse within one working day.
Lula has paid out over R13 billion to help more than 30,000 small businesses grow since 2014.
Working capital tells you where your business stands today. Working capital finance helps you act on it, protecting what you built and funding what comes next.
Disclaimer: This article is for general information purposes only and does not constitute financial advice. Please consult a qualified financial professional regarding your specific circumstances.
