What is Working Capital and Why Is it Important?

By: Nicole Evans, Grand Forks Center Director

Understanding Working Capital

We often hear the term working capital, and we may even use it regularly in business, but what exactly does it mean, and why is it important to understand?

Working capital represents the operating liquidity available to a business and is considered a component of operating capital. It is the difference between a company’s current assets and current liabilities, calculated by subtracting current liabilities from current assets as listed on the company’s balance sheet.

Understanding working capital helps you determine whether your company can withstand a crisis or unexpected downturn. If your business maintains positive working capital, you will have a greater ability to pay employees, suppliers, and other short-term obligations. Even if your business does not need to borrow money, demonstrating positive working capital makes it easier to qualify for loans or lines of credit.

There are typically busier months than others in a business cycle. For example, you might generate 60 percent of your revenue in November and December, but that revenue needs to cover a substantial portion of expenses throughout the year. By establishing and maintaining a buffer, you can plan when you might need to hire temporary help for the busy season or when it is best to stock up on supplies.

How Working Capital Impacts Cash Flow

Let’s take a quick look at cash flow. How does working capital affect cash flow?

Cash flow is the amount of cash and cash equivalents that move in and out of your business during an accounting period. If your revenue decreases and your company experiences a negative cash flow as a result, it will draw from your working capital.

Here are six ways to increase your working capital:

1. Take on long-term debt. This increases your current assets by adding available cash but does not substantially increase your current liabilities.
2. Refinance your short-term debt to long-term debt. This reduces your current liabilities. Current liabilities are debts due within a year, and long-term liabilities are debts due after one year.
3. Sell liquid assets for cash. This will increase your current assets.
4. Reduce expenses. This will decrease your current liabilities.
5. Optimize inventory by reducing overstocking.
6. Automate accounts receivable. This can increase cash flow and reduce the need to draw from your working capital.

Understanding financial fundamentals like working capital is key to long-term stability and success. Whether you are navigating cash flow challenges, planning for seasonal fluctuations, or trying to make sense of your balance sheet, you do not have to do it alone. The North Dakota Small Business Development Centers (ND SBDC) are here to help you build financial confidence and clarity. Our knowledgeable advisors can guide you through these essential topics and more, providing personalized, no-cost support tailored to your business needs. Connect with your local ND SBDC advisor today to schedule an appointment and take the next step toward a stronger financial future.