What is working capital?

Working capital is the difference between current assets and short-term liabilities, and represents a company's ability to finance its day-to-day operations. Working capital is a critical measure of liquidity and financial health , showing whether a company can meet its short-term obligations. Good working capital management is fundamental to maintaining solvency and ensuring a company's financial stability.

Section 1: Definition and Basic Principles

1.1 What is Working Capital?

Working capital is calculated as:

Working capital = Current assets - Current liabilities

This measure shows how much liquid resources the company has available after all short-term obligations have been met. A positive working capital indicates that the company has sufficient resources to operate the business, while a negative working capital may signal liquidity problems .

1.2 Components of Working Capital

Working capital consists of two main components found on the balance sheet :

Current assets (Assets)

• Cash and bank deposits : Most liquid assets
• Accounts receivable: Money customers owe the company
• Inventory: Raw materials, work in progress, and finished goods
• Prepaid costs: Prepaid expenses
• Short-term investments: Securities that can be sold quickly

Short-term Debt (Liabilities)

• Accounts payable: Money the company owes to suppliers
• Accrued costs: Expenses earned but not paid
• Short-term loans: Loans that mature within one year
• Tax debt: Tax owed to the government
• Other current liabilities: Miscellaneous current liabilities

Section 2: Calculation and Analysis of Working Capital

2.1 Practical calculation example

Let's look at a concrete example from a Norwegian company:

Current assets	Amount (NOK)	Short-term Debt	Amount (NOK)
Cash	500,000	Accounts payable	800,000
Accounts receivable	1,200,000	Costs incurred	300,000
Inventory	800,000	Short-term loans	400,000
Prepaid	100,000	Tax debt	200,000
Total current assets	2,600,000	Total short-term debt	1,700,000

Working capital = 2,600,000 - 1,700,000 = 900,000 NOK

2.2 Working Capital Ratios

To analyze working capital, several important key figures are used:

Key figures	Formula	Interpretation
Liquidity ratio 1	Current assets ÷ Current liabilities	Should be > 1.0 for good liquidity
Liquidity ratio 2	(Current assets - Inventories) ÷ Current liabilities	Should be > 0.7 for solid liquidity
Working capital ratio	Working capital ÷ Total assets	Shows the proportion of assets that are working capital
Cash conversion cycle	DIO + DSO - DPO	Time from investment to cash inflow

2.3 Industry-Specific Differences

Working capital needs vary significantly between industries:

• Retail: High inventory, low accounts receivable
• Production: High inventory and accounts receivable
• Services: Low inventories, high accounts receivable
• Construction: High accounts receivable, variable inventories

Section 3: Working Capital Components in Detail

3.1 Accounts Receivable

Accounts receivable represent money owed by customers for goods or services provided. Effective management of accounts receivable is critical to working capital. For an in-depth understanding of accounts receivable and accounts receivable management, see our comprehensive guide.

Accounts Receivable Optimization

• Credit Check: Assess customers' creditworthiness before selling
• Payment Terms: Offer discounts for early payment
• Automatic reconciliation: Use BankGiro for faster payments and automatic reconciliation
• Follow-up: Systematic follow-up of overdue receivables through payment reminders
• Factoring: Sell receivables to financial institutions for instant cash

3.2 Inventory

Inventory ties up significant working capital and must be balanced between availability and costs.

Warehouse optimization

• Just-in-time: Reduce inventory levels through better planning
• ABC analysis: Prioritize management of high-value goods
• Inventory Turnover Rate: Increase how often inventory is turned over
• Seasonal planning: Adjust inventory levels to seasonal variations

For retail, inventory optimization is particularly critical due to high transaction volume, many product lines, and challenges such as shrinkage and theft that significantly impact working capital.

3.3 Accounts Payable

Accounts payable is an important source of financing that can be optimized for better working capital.

Accounts Payable Strategies

• Payment terms: Negotiate longer payment terms
• Supplier financing: Use suppliers' credit facilities
• Cash discounts: Consider whether early payment is worthwhile
• Centralized purchasing: Achieve better conditions through volume

Section 4: Working Capital Management and Optimization

4.1 Working capital strategies

Companies can choose between different working capital management strategies:

Conservative Strategy

• High working capital: Large safety buffer
• Low risk: Reduced risk of liquidity problems
• Higher costs: More capital tied up
• Lower returns: Less efficient use of capital

Aggressive Strategy

• Low working capital: Minimal safety buffer
• High risk: Increased risk of liquidity problems
• Lower costs: Less capital tied up
• Higher returns: More efficient use of capital

4.2 Cash flow management

Working capital directly affects a company's cash flow and must be coordinated with:

• Budgets: Plan working capital needs
• Forecasts: Predicting seasonal variations
• Financing: Secure sufficient credit limit
• Advance payments: Use advances to improve cash flow
• Monitoring: Continuous follow-up of key figures

Section 5: Working Capital in the Accounting

5.1 Presentation in the Annual Accounts

Working capital does not appear directly in the financial statements , but is calculated from balance sheet information. For an in-depth understanding of the structure of the balance sheet and how working capital components fit into the overall picture, see our comprehensive guide to balance sheet accounting .

Balance sheet presentation

ASSETS (ASSETS) * Fixed assets * Current assets ← Part of working capital - Inventory - Accounts receivable - Cash and bank deposits

DEBT AND EQUITY * Equity * Long-term debt * Short-term debt ← Part of working capital - Accounts payable - Other short-term debt

5.2 Cash flow statement

The cash flow statement shows changes in working capital that affect cash flow from operations:

Change in working capital components	Effect on cash flow
Increase in accounts receivable	Negative (less cash)
Reduction in accounts receivable	Positive (more cash)
Increase in inventory	Negative (less cash)
Reduction in inventory	Positive (more cash)
Increase in accounts payable	Positive (more cash)
Reduction in accounts payable	Negative (less cash)

Section 6: Working Capital and Financial Analysis

6.1 Liquidity analysis

Working capital is the basis for liquidity analysis , which assesses the company's ability to pay:

Liquidity levels

1. Initial liquidity: Cash and bank deposits
2. Other liquidity: + short-term investments
3. Third liquidity: + accounts receivable
4. Fourth liquidity: + inventory (total current assets)

6.2 The Impact of Working Capital on Profitability

Working capital affects profitability through:

• Cost of capital: Tied up capital has a cost that affects break-even analysis
• Operational efficiency: Optimal working capital improves operations
• Growth opportunities: Adequate working capital enables growth
• Risk Management: Balancing Risk and Return

Effective working capital management directly impacts a company's gross profit by optimizing costs related to inventory, accounts receivable, and accounts payable.

To analyze how working capital affects profitability at different levels of the organization, departmental accounting can be a valuable tool for measuring efficiency and capital allocation per department.

Section 7: Practical Tips for Working Capital Management

7.1 Daily Working Capital Management

Routines for Optimal Management

• Daily cash report: Monitor your liquidity situation
• Weekly receivables overview: Follow up on overdue receivables with payment requests
• Monthly inventory analysis: Assess inventory levels and turnover rate
• Quarterly Strategy Review: Evaluate Working Capital Strategy

7.2 Technology and Automation

Modern technology can improve working capital management:

• ERP systems: Integrated management of all components
• Automatic invoicing: Reduce time from delivery to invoice
• Electronic payment: Faster payment from customers
• Predictive Analytics: Forecasting Working Capital Needs

Section 8: Working Capital in Different Life Stages

8.1 Start-up phase

Challenges: * High working capital requirements * Limited access to financing * Uncertain cash flows

Strategies: * Conservative approach * Focus on cash flow * Minimize inventory * Consider alternative forms of financing such as crowdsourcing

8.2 Growth phase

Challenges: * Increasing working capital needs * Rapid growth in accounts receivable * Scaling operations

Strategies: * Balanced approach * Invest in systems * Professionalize credit management

8.3 Mature phase

Challenges: * Optimize efficiency * Competition on margins * Stable but lower growth rates

Strategies: * Aggressive optimization * Focus on capital turnover * Advanced management tools

Conclusion

Working capital is a fundamental concept in financial management that requires continuous attention and optimization. By understanding the relationship between current assets and short-term liabilities, companies can improve their liquidity , reduce financing costs , and increase profitability .

Effective working capital management requires:

• Systematic monitoring of key figures and trends
• Balanced approach between risk and return
• Integrated management of all working capital components
• Continuous improvement of processes and systems

For more information on related topics, see our articles on assets , trial balance , and accounting .