A profitable business can still fail to pay its wages on a Friday. Profit is earned when an invoice is raised; cash arrives when it is paid, often 30 to 90 days later, while stock, staff and suppliers have to be paid in the meantime. Working capital is the measure of that gap. This guide shows how to calculate it, how to read the result and which levers move it.
The working capital formula
The basic calculation uses two lines from your balance sheet:
Working capital = current assets − current liabilities
Current assets are items you expect to turn into cash within twelve months: cash at bank, trade debtors (unpaid customer invoices), stock and work in progress, and prepayments. Current liabilities are amounts due within twelve months: trade creditors, VAT and PAYE owed, corporation tax due, bank overdrafts, and the next twelve months of loan or hire purchase instalments.
The result is often called net working capital to distinguish it from "gross" working capital, which is just the current assets total. A positive figure means short-term assets cover short-term liabilities; a negative figure means they do not.
Working capital ratio (current ratio): current assets ÷ current liabilities. It expresses the same relationship as a multiple rather than a pound figure, so businesses of different sizes can be compared.
Worked example: a balance sheet calculation
The table below shows a simplified year-end balance sheet for a distribution business with £1.2m of annual turnover. Replace the figures with your own to do the same calculation.
| Line | Item | Amount |
|---|---|---|
| A | Cash at bank | £30,000 |
| B | Trade debtors | £200,000 |
| C | Stock | £100,000 |
| D | Total current assets (A + B + C) | £330,000 |
| E | Trade creditors | £90,000 |
| F | VAT and PAYE due | £40,000 |
| G | Overdraft | £50,000 |
| H | Total current liabilities (E + F + G) | £180,000 |
| I | Net working capital (D − H) | £150,000 |
| J | Working capital ratio (D ÷ H) | 1.83 |
On paper this business looks comfortable: £150,000 of headroom and a ratio of 1.83. But look at where the current assets sit. Only £30,000 is cash. The other £300,000 is in invoices waiting to be paid and stock waiting to be sold. If the monthly wage bill is £60,000 and the overdraft is at its limit, the business is two weeks from a problem despite a healthy ratio. That is why the second calculation matters more for day-to-day management.
The working capital cycle
The working capital cycle (also called the cash conversion cycle) measures how many days cash is tied up between paying for stock or labour and collecting the resulting sale. It combines three figures:
Working capital cycle = debtor days + stock days − creditor days
- Debtor days = (trade debtors ÷ annual credit sales) × 365
- Stock days = (stock ÷ annual cost of sales) × 365
- Creditor days = (trade creditors ÷ annual cost of sales) × 365
Using the same business, with annual sales of £1,200,000 and cost of sales of £800,000:
Illustrative example Working capital cycle for the distribution business
- Debtor days (£200,000 ÷ £1,200,000 × 365)
- 61 days
- Stock days (£100,000 ÷ £800,000 × 365)
- 46 days
- Creditor days (£90,000 ÷ £800,000 × 365)
- 41 days
- Working capital cycle (61 + 46 − 41)
- 66 days
Figures are illustrative estimates only and do not represent a finance offer.
Every pound this business spends on stock is out of the bank for roughly 66 days before the customer's payment brings it back. Multiply that by daily cost of sales (£800,000 ÷ 365, about £2,190) and the cycle ties up around £145,000 permanently, which is almost exactly the net working capital figure above. The two calculations are looking at the same money from different angles.
What good looks like
There is no single correct answer, because sectors differ. A supermarket sells for cash and pays suppliers in 60 days, so it runs a negative cycle and can operate with a ratio below 1. A manufacturer or a recruitment agency paying staff weekly and invoicing monthly cannot. As rough guides for a trading business:
- A working capital ratio between 1.2 and 2.0 is usually considered healthy. Below 1.0 is a warning sign; above 3.0 often means cash or stock sitting idle.
- Debtor days should be close to your stated payment terms. If terms are 30 days and debtor days are 61, collection is the problem, not the terms. See our guide to invoice payment terms.
- A shorter cycle is better. Each day removed from the cycle releases roughly one day's cost of sales in cash.
- The trend matters more than the snapshot. A ratio falling from 1.8 to 1.3 over three quarters needs attention even though 1.3 is acceptable.
How to improve each lever
Reduce debtor days
Invoice on the day work is completed, state due dates as calendar dates, chase before the due date, resolve queries within 48 hours and charge statutory interest where relationships allow. Reducing debtor days from 61 to 45 in the example releases about £53,000.
Reduce stock days
Identify slow lines and clear them, order smaller quantities more often, and agree call-off arrangements with suppliers so stock is held on their books rather than yours. Cutting stock days from 46 to 35 releases about £24,000.
Extend creditor days, carefully
Negotiate longer supplier terms rather than simply paying late, which damages supply and can trigger statutory interest against you. Moving from 41 to 50 creditor days frees about £20,000, but it is the least reliable lever because suppliers can withdraw it at any time.
Our guide on improving business cash flow goes through these actions in more detail.
How invoice finance changes the picture
Trade debtors are usually the largest and least controllable current asset. Invoice finance addresses them directly: a provider typically advances a large proportion of each approved invoice, often 70% to 90% depending on the provider and sector, shortly after it is raised. In the example, an 85% advance against £200,000 of debtors would release about £170,000 of cash, clear the £50,000 overdraft and leave a sizeable buffer.
It is important to be honest about what that does to the figures:
What improves
- Cash replaces debtors, so liquidity improves immediately and the effective working capital cycle shortens by most of your debtor days.
- Funding grows automatically with sales, unlike a fixed overdraft.
- With factoring, the provider's credit control may also reduce debtor days on the unfunded balance.
What does not
- Under invoice discounting the advance is a current liability repaid from customer receipts, so net working capital barely moves; the balance sheet simply swaps debtors for cash and a matching liability.
- Under factoring the debts are sold, so debtors fall and cash rises, but the service fee and discount charge reduce profit and therefore retained working capital over time.
- Charges accrue for every day funds are outstanding, so a long cycle costs more to finance. See the costs guide.
Invoice finance is a tool for converting one asset into another faster. It does not fix a business that is unprofitable, overstocked or paying suppliers late for structural reasons. Our comparison of invoice finance and business loans helps decide which type of funding suits a given working capital gap.
Debtors are your biggest current asset?
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Summary
- Working capital = current assets − current liabilities; the ratio is current assets ÷ current liabilities.
- The working capital cycle (debtor days + stock days − creditor days) shows how long cash is tied up and is the better day-to-day measure.
- Each day cut from the cycle releases roughly a day's cost of sales in cash.
- Invoice finance converts debtors into cash quickly, improves liquidity and scales with sales, but it is a cost and, under discounting, a liability.
Frequently asked questions
What is the working capital formula?
Working capital equals current assets minus current liabilities. Current assets are cash, trade debtors, stock and other items expected to turn into cash within a year. Current liabilities are trade creditors, VAT and PAYE owed, overdrafts and any loan instalments due within a year.
What is a good working capital ratio?
A ratio of current assets to current liabilities between about 1.2 and 2.0 is generally considered healthy for a trading business, although the right figure depends on the sector. Below 1.0 the business owes more in the short term than it holds, which is a warning sign. A very high ratio can mean cash or stock is sitting idle.
Is working capital the same as cash flow?
No. Working capital is a snapshot of short-term assets less short-term liabilities on a given date. Cash flow is the movement of money in and out over a period. A business can show positive working capital and still run out of cash if its debtors and stock cannot be turned into money quickly enough to meet wages and suppliers.
Does invoice finance count as working capital?
Invoice finance converts trade debtors into cash sooner, which improves liquidity and shortens the working capital cycle. Under invoice discounting the advance is shown as a current liability, so net working capital itself barely changes; under factoring the debts are sold, so debtors fall and cash rises. Either way the facility carries fees that reduce profit.