Working capital shows whether a business can pay its short-term bills. It compares what a business owns in the short term to what it owes in the short term. This guide explains working capital in clear terms for beginners.
Who This Guide Is For
This guide is for:
- Small business owners
- Freelancers and self-employed workers
- Career switchers learning accounting basics
- Students and non-finance professionals
No prior accounting knowledge is required.
What Is Working Capital?
Working capital is the difference between current assets and current liabilities.
Simple definition:
Working capital measures a business’s short-term financial health.
Formula:
Working Capital = Current Assets − Current Liabilities
If current assets are higher than current liabilities, working capital is positive.
Why Working Capital Matters
Working capital shows whether a business can:
- Pay suppliers on time
- Cover rent, salaries, and utilities
- Handle short-term expenses
- Continue daily operations without stress
A business can be profitable but still fail if it runs out of working capital.
What Are Current Assets?
Current assets are items a business expects to turn into cash within one year.
Common current assets include:
- Cash
- Bank balances
- Accounts receivable
- Inventory
- Short-term investments
These assets support daily business operations.
What Are Current Liabilities?
Current liabilities are obligations due within one year.
Common current liabilities include:
- Accounts payable
- Short-term loans
- Rent payable
- Utilities payable
- Taxes payable
These are bills the business must settle soon.
Working Capital Explained With a Simple Example
A small business has:
- Cash: ₦200,000
- Accounts receivable: ₦150,000
- Inventory: ₦250,000
Total current assets = ₦600,000
The business also has:
- Accounts payable: ₦300,000
- Short-term loan: ₦100,000
Total current liabilities = ₦400,000
Working capital = ₦600,000 − ₦400,000 = ₦200,000
This means the business can meet short-term obligations comfortably.
Positive vs Negative Working Capital
Positive Working Capital
Positive working capital means current assets exceed current liabilities.
This usually indicates:
- Better cash flow
- Lower risk of missed payments
- Smoother daily operations
Negative Working Capital
Negative working capital means liabilities are higher than assets.
This may cause:
- Cash shortages
- Delayed supplier payments
- Difficulty paying staff or rent
Negative working capital is a warning sign for many businesses.
Is High Working Capital Always Good?
Not always.
Very high working capital can mean:
- Too much cash sitting idle
- Excess inventory not selling
- Poor use of available funds
The goal is healthy working capital, not the highest possible number.
Working Capital vs Cash
Working capital is not the same as cash.
- Cash is only one part of current assets
- Working capital includes receivables and inventory
- A business can have working capital but low cash
This is why cash flow planning is important.
Working Capital vs Profit
Profit shows long-term success.
Working capital shows short-term survival.
A business can:
- Be profitable but lack working capital
- Have working capital but be unprofitable
Both must be monitored regularly.
How to Improve Working Capital
Businesses can improve working capital by:
- Collecting customer payments faster
- Reducing unnecessary inventory
- Negotiating longer payment terms with suppliers
- Avoiding excessive short-term borrowing
Small changes can make a big difference.
Working Capital in Small Businesses
Small businesses rely heavily on working capital because:
- Cash reserves are usually limited
- Delays in customer payments affect operations
- Unexpected expenses are harder to absorb
Tracking working capital monthly helps prevent surprises.
Working Capital for Freelancers
Freelancers also need working capital.
Examples include:
- Cash to cover internet, power, and tools
- Funds to survive delayed client payments
- Savings for slow months
For freelancers, working capital often equals cash plus unpaid invoices.
How Working Capital Appears in Financial Statements
Working capital is calculated from the balance sheet.
- Current assets appear at the top
- Current liabilities appear below
- The difference represents working capital
Understanding the balance sheet helps track working capital accurately.
Common Working Capital Mistakes
- Ignoring unpaid customer invoices
- Mixing personal and business cash
- Overbuying inventory
- Relying only on profit figures
- Not reviewing short-term liabilities
Avoiding these mistakes improves financial stability.
How Often Should Working Capital Be Reviewed?
Most small businesses should review working capital:
- Monthly
- Before major purchases
- Before taking new loans
Regular reviews prevent cash flow problems.
Working Capital Ratios
Some businesses use ratios to assess working capital health.
Current Ratio:
Current Assets ÷ Current Liabilities
A ratio above 1 usually indicates adequate working capital.
Ratios support analysis but do not replace cash monitoring.
FAQ: Working Capital Explained
What is working capital in simple terms?
Working capital shows if a business can pay short-term bills using short-term assets.
Is working capital the same as profit?
No. Profit measures earnings, while working capital measures short-term financial ability.
Can a business survive with negative working capital?
Some businesses can temporarily, but it increases financial risk.
Do freelancers need working capital?
Yes. Freelancers need working capital to manage delayed payments and expenses.
What happens if working capital is zero?
Zero working capital means assets equal liabilities, leaving no margin for unexpected costs.
Key Takeaways
- Working capital measures short-term financial health
- It equals current assets minus current liabilities
- Positive working capital supports daily operations
- Too little or too much working capital can be risky
- Regular tracking helps avoid cash problems
Understanding working capital helps businesses stay stable and prepared.
