Working capital is one of those business terms that sounds more complicated than it really is.
Put simply, working capital is the money available to keep your business running day to day.
You need it to pay wages, suppliers, rent, tax and other operating expenses. You may also need working capital to buy stock, take on a large new order, hire additional people or cover the gap between doing the work and getting paid for it.
And importantly, a business can be profitable and still have a working capital problem.
Understanding how working capital works can help you spot potential cash flow problems earlier – and work out whether you need to improve the way cash moves through the business or consider additional finance.
What is working capital?
In accounting terms, working capital is calculated as:
Current assets – current liabilities = working capital
Current assets are things your business expects to turn into cash within the short term, such as:
cash in the bank
accounts receivable (money customers owe you)
stock or inventory.
Current liabilities are amounts your business needs to pay in the short term, such as:
supplier accounts
wages
tax obligations
loan repayments and other short-term debts.
If your current assets are greater than your current liabilities, you have positive working capital.
But the accounting calculation only tells part of the story.
For a business owner, the more practical question is often:
Do we have enough money available, at the right time, to meet our obligations and keep the business operating?
That is where working capital becomes particularly important.
Working capital, cash flow and profit aren't the same thing
It's easy to assume that a profitable business should have plenty of cash available. Unfortunately, it doesn't always work that way.
Imagine your business completes $100,000 worth of work this month. On paper, that revenue may contribute to a healthy profit.
But if your customers don't pay you for another 30, 60 or even 90 days, you still need to fund the costs of delivering that work in the meantime.
Your employees expect to be paid. Your suppliers may need paying. There may be GST, rent, insurance and other expenses falling due.
So while the business may be profitable, the cash hasn't arrived yet.
This is one of the reasons growing businesses can experience working capital pressure. More sales and more work can actually increase the amount of cash the business needs.
Why is working capital important?
Adequate working capital gives a business room to operate.
Without it, even ordinary expenses can become stressful. Owners may find themselves constantly juggling payments, delaying suppliers or waiting for a particular customer invoice to be paid before they can meet another obligation.
With sufficient working capital, a business is better placed to:
meet its regular expenses when they fall due
manage unexpected costs
purchase stock and materials
take advantage of new opportunities
accept larger contracts or orders
invest in growth
manage seasonal fluctuations
withstand customers paying later than expected.
Working capital isn't only about surviving a difficult period. It can also determine whether a business is able to grow.
Why do businesses run short of working capital?
There isn't one single cause.
Sometimes a working capital shortage is a sign that the business is struggling. But that isn't always the case.
In fact, some perfectly healthy businesses experience working capital pressure simply because of the way money moves through their business.
Customers take a long time to pay
This is particularly common in businesses that sell to other businesses.
You may have completed the work and issued the invoice, but if your customer pays on the 20th of the following month or operates on 60-day terms, there can be a considerable delay before the money reaches your bank account.
Meanwhile, you've already incurred the costs of providing the product or service.
You need to buy stock or materials upfront
Retailers, wholesalers, manufacturers, importers and many other businesses need to spend money before they can generate the corresponding revenue.
The larger the order or opportunity, the more working capital may be required.
Your business is growing quickly
Growth consumes cash.
A growing business may need more staff, more stock, more vehicles, more equipment or larger premises. Even when sales are increasing strongly, there can be a significant lag between paying those additional costs and receiving the resulting revenue.
This can create an interesting problem: the business needs more working capital because it is succeeding, not because it is failing.
Your business is seasonal
Some businesses have predictable periods when cash comes in faster than others.
If you need to purchase stock, hire seasonal staff or meet other costs before your busiest period begins, you may need additional working capital to bridge the gap.
A large payment falls due
GST, provisional tax, insurance premiums, equipment repairs or an unexpected supplier bill can put temporary pressure on cash reserves.
Even businesses with generally healthy cash flow can occasionally find that several significant payments fall due at the same time.
What are the signs of a working capital problem?
Working capital pressure often appears gradually.
You may notice that you are increasingly waiting for money to arrive before paying bills, stretching supplier payment terms, using personal funds to cover business expenses or regularly reaching the limit of an existing overdraft or credit facility.
Another warning sign is when a business appears busy and profitable, but there never seems to be enough cash in the bank.
If this happens occasionally because of a known timing issue, it may simply be a cash flow mismatch.
If it happens continually, however, it's worth looking more closely at what is driving the problem.
Finance can help with a timing gap. It generally won't solve an underlying business model that consistently spends more cash than it generates.
How can you improve working capital?
Borrowing isn't necessarily the first or only answer.
There may be opportunities within the business to release cash or reduce the amount of working capital required.
For example, you could look at:
invoicing customers as soon as work is completed
following up overdue accounts more quickly
reviewing the payment terms you offer customers
negotiating better terms with suppliers
reducing excess or slow-moving stock
asking for deposits or progress payments on larger jobs
reviewing expenses and unnecessary cash outflows
improving cash flow forecasting.
Sometimes relatively small changes can make a noticeable difference.
But there are also situations where external finance makes sense – particularly when the business has a temporary cash flow gap or needs additional working capital to support growth.
What finance can be used for working capital?
There isn't one particular type of "working capital finance" that suits every business.
The right option depends on why you need the money, how much you need, how long you need it for and how your business generates revenue.
Business loans
A business loan can provide a lump sum that can be used for working capital, stock purchases, expansion or other business purposes.
Loans may be secured or unsecured, and repayment terms, lending criteria and pricing vary considerably between lenders.
Invoice finance
For businesses that sell to other businesses on credit terms, invoice finance can be particularly useful.
Rather than waiting for customers to pay their invoices, the business can access some of that money earlier.
This can be useful where the underlying working capital problem isn't a lack of sales – it's simply that customers pay later than the business needs the cash.
line of credit facilities
A line of credit facility can provide flexibility where working capital requirements move up and down.
Rather than borrowing a fixed amount for a fixed purpose, the business can generally draw funds when required and repay them as cash becomes available, subject to the terms of the facility.
Secured lending
Property or other business assets may sometimes be used to support additional borrowing.
Depending on the circumstances, secured lending can provide access to larger amounts or different lending terms than an unsecured facility. Similarly, a second mortgage could give you access to a larger loan than a standard business loan, depending on the LVR in your property or the number of properties you own.
The important point is that the best finance option depends on the reason for the working capital requirement.
A business waiting 60 days for customers to pay invoices has a different funding problem from a business needing $200,000 to purchase stock for a major new contract.
They shouldn't automatically be given the same finance solution.
How much working capital does your business need?
There isn't a standard amount that every business should have.
A professional services business with very little stock and customers who pay promptly may require relatively little working capital.
An importer that needs to purchase several months' stock before selling it may require considerably more.
The amount you need can also change as your business grows.
A useful starting point is a cash flow forecast showing when money is expected to come in and when major expenses need to be paid.
Rather than simply asking "How much can I borrow?", it can be more useful to ask:
How large is the funding gap, how long will it exist, and what is causing it?
Those answers can help determine both the amount of finance required and the most appropriate type of facility.
Choosing the right working capital finance
There are many lenders offering business finance in New Zealand, and their lending criteria, products and appetite for different types of businesses vary.
The lender or product that works well for one business may not be the best fit for another.
That's one of the reasons businesses use a finance broker.
At NZ Business Finance, we look at what you're trying to achieve, why the business needs funding and how the finance will be repaid before considering which funding options and lenders may be suitable.
Sometimes that might be a traditional business loan. In other circumstances it could be invoice finance, a revolving facility, secured lending or another form of business finance.
The goal isn't simply to find finance. It's to find finance that fits the way your business operates.
If your business needs additional working capital – whether to manage a short-term cash flow gap, purchase stock, take on a new contract or support growth – talk to NZ Business Finance about the funding options available.
Frequently asked questions about working capital
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Description text goes hereWorking capital is the money a business has available to meet its day-to-day operating costs and short-term financial obligations. It is calculated by subtracting current liabilities from current assets. In practical terms, having enough working capital means having enough money available at the right time to pay suppliers, wages, tax and other expenses while keeping the business operating.
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Working capital is a measure of a business's short-term financial position, while cash flow describes the money moving into and out of the business over a period of time. The two are closely related. A business can have valuable assets and money owed by customers but still experience cash flow pressure if that money isn't available when bills need to be paid.
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Yes. A profitable business can still run short of working capital, particularly if customers take a long time to pay or the business needs to pay for stock, materials, wages or other costs before receiving the corresponding revenue. Rapidly growing businesses can also experience working capital pressure because they need to fund increased activity before the additional cash comes in.
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Yes. Business loans can be used to provide working capital, but a standard business loan isn't always the most appropriate option. Depending on why you need the money and how your business operates, alternatives such as invoice finance, revolving credit or secured business finance may be more suitable.
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The amount varies considerably between businesses. A good starting point is a cash flow forecast showing when you expect to receive money and when your major expenses fall due. This can help identify the size and duration of any funding gap. If external finance is required, understanding what is causing the gap can also help determine which type of finance is most appropriate.