A company’s working capital and cash flow are intrinsically linked, and understanding this relationship is vital for efficient money management. Here we discuss the key differences, how changes in working capital directly impact cash flow and the finance solutions that can help businesses maintain a healthy balance.
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Small businesses can face various working capital challenges, from navigating economic uncertainty and seasonal fluctuations to increasing overheads and inventory management. Without consistent liquidity, growing your business can feel like an impossible task.
Before looking at ways to address these challenges, let’s clarify what working capital means and how it differs from and relates to cash flow.
While being closely linked, there are distinct differences between working capital and cash flow. So, let’s look at each concept and how they’re calculated.
Working capital is the money available (liquidity) to your business to cover various operational costs and financial obligations, like rent, salaries, etc. It represents the difference between your assets (cash in the bank, accounts receivables and inventory) and your existing liabilities (accounts payable, taxes, outstanding expenses and short-term debts).
Working capital is a snapshot of your company’s financial health. Calculating your working capital, or net working capital (NWC) [anchor link to FAQ] – as your amount is ‘net’ of liabilities – is a good measure of liquidity and operational efficiency.
The equation for calculating net working capital is:
Net working capital = current assets - current liabilities
You can also calculate your working capital ratio by dividing your current assets by current liabilities. A working capital ratio between 1.2 and 2.0 is typically considered healthy.
It’s worth considering your non-cash working capital (NCWC), which excludes cash/cash equivalents from your assets to establish the working capital tied up in operations.
A positive number indicates your business has liquidity available to manage operations, fulfil obligations and invest in the future. Negative working capital means your liabilities outweigh your assets.
It’s important to note that overly high working capital can be a sign your company has either too much cash tied up in inventory or outstanding receivables or isn’t investing enough liquidity into driving business growth.
PwC’s 2024 working capital study revealed that €1.56 trillion in excess working capital globally could be freed up for investment in operational transformation. The study also suggests the ‘just in case’ stocking approach seen during the pandemic has evolved into a ‘just because’ ethos, which hinders working capital.
For more on working capital calculations and ratios, read our guide to working capital.
In simple terms, cash flow is the money coming in and out of your business, covering a specific period, such as a month, quarter or year.
The formula for calculating cash flow is:
Cash flow = net income + depreciation - capital expenditure - change in working capital
Cash flow and working capital data provide important insights about your company’s financial health, ability to manage expenditures, room for growth and potential needs for external funding.
Due to the close relationship between working capital and cash flow, various factors influencing working capital will impact cash flow.
Aspiring to both a high net working capital and positive cash flow figures is not necessarily realistic or beneficial. Excessive working capital can signify inefficiency, as a lot of cash may be tied up in assets that could be used for operational needs or revenue-generating opportunities.
Explore our top tips for managing your working capital. [Anchor link to the section]
With nearly a quarter of new businesses failing in their first year and 60% of small businesses citing ineffective cash flow management as a major challenge, it’s crucial to identify root causes and see how an increase in working capital affects cash flow.
Here are the main factors impacting working capital:
Business owners and financial decision-makers should have a clear view of working capital and cash flow, particularly periodic changes in working capital. Your working capital changes are reflected in the cash flow statement, amongst operating activities. This represents reporting adjustments to reconcile net income with the cash generated or spent on business operations.
Accurate cash flow forecasting and management rely on understanding how changes in working capital can affect future cash availability. For example, in the lead-up to peak seasonal periods, you may purchase a lot of stock to meet demand, reducing available cash, or perhaps you’re expecting receivables to increase due to extended credit terms. Predicting working capital changes and planning accordingly is vital to maintaining healthy liquidity.
Market conditions, seasonality and the nature of your business all impact working capital and, in turn, your cash flow. So, you need smart forecasting, proactive financing planning and strong working capital management, including shortening your working capital cycle (the time it takes to convert working capital assets to cash).
Holding stock for too long restricts your cash flow. Inventory monitoring, demand planning and just-in-time (JIT) inventory systems help reduce inefficiencies, minimising risks of stockouts and carrying excess inventory, freeing up cash for other purposes.
The faster you get paid, the more cash at your fingertips. Find ways to accelerate cash collections, such as setting clear payment terms, offering discounts for early payments and using automated invoice-chasing tools.
Actively review operational costs to identify and eliminate unnecessary expenses, while exploring more cost-effective options to reduce outgoings and free up working capital.
Implement clear payment schedules and align regular payments with income, where possible. Developing good supplier relationships can lead to more flexible and favourable payment terms, aiding cash retention in key periods.
Financial analysis and forecasting software can help SMEs monitor and predict working capital needs and project cash flow, which helps you run smoother operations.
Diversifying your offering generates new revenue streams, so you’re less reliant on existing ones, which can suffer from a drop in sales or delayed payments, destabilising cash flow.
Seeking additional funding, such as working capital loans, provides breathing space, greater flexibility and a reserve to help manage day-to-day operations, alongside cash flow and working capital management.
Working capital finance provides a cash injection that gives businesses more scope for growth, whether you want to expand into new markets, upgrade systems, increase advertising spend or seek bigger contracts.
Working capital loans and cash flow loans can be used to:
Working capital finance helps UK companies remain competitive amidst ongoing economic instability. Here are the benefits of using working capital finance:
iwoca is a leading flexible loan provider for small businesses, helping you overcome working capital challenges and invest in your future.
Our popular Flexi-Loan solution was designed to address working capital needs and provides quick and easy access to funds, with affordable monthly repayment terms. You can apply online in minutes and borrow £1,000 to £1,000,000 for between a day and five years – and you can expect a decision within 24 hours.
Plus, we don’t charge for early repayments and you only pay interest on the funds you use.
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No. Working capital is the difference between a company's current assets and liabilities while cash flow is the movement of money in and out of the business over a certain period.
You can determine working capital changes in your cash flow statement. To calculate changes in net working capital, subtract the previous period's working capital (assets - liabilities) from the current period's working capital. The net working capital (NWC) change formula is as follows: Current assets (in the new period) - current liabilities (in the previous period).
An increase in working capital can decrease cash flow because cash can be tied up in operational assets like accounts receivable or inventory. This reduces liquidity until assets are converted into cash, restricting available funds.
Working capital loans are a flexible funding option that offers access to additional liquidity for things like seasonal inventory demands, new equipment, increased payroll and cash flow gaps. They help small businesses with growing expenses, flagging sales or other temporary financial challenges.
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