Working Capital: Definition and Formula

The formula and what it includes

Working Capital = Current Assets − Current Liabilities. Current assets typically include cash, accounts receivable, inventory, and prepaid expenses. Current liabilities include accounts payable, accrued expenses, the current portion of long-term debt, and short-term notes.

A positive number means the firm could, in principle, settle its short-term obligations using its short-term assets. A negative number doesn't always mean trouble — some businesses (subscription, consumer retail) intentionally operate on negative working capital because they collect from customers before paying suppliers — but for service businesses with longer collection cycles, negative working capital is usually a warning.

Why owners track the change, not the level

Static working capital tells you whether the business can theoretically meet obligations. Change in working capital tells you whether operations are consuming cash or releasing it. Growing receivables or inventory faster than payables consumes cash even if the P&L looks healthy.

On the cash flow statement, the indirect method explicitly subtracts increases in working capital from net income to reconcile to cash from operations. This is exactly where 'profitable but cash-poor' businesses become visible.

Why working capital eats cash

Growth consumes working capital. When revenue doubles, receivables roughly double, inventory roughly doubles, and payables only partially offset because suppliers won't extend terms as fast as customers consume them. A profitable business growing 50% per year can easily need a cash injection equal to one or two months of revenue just to fund the working-capital expansion — and that's before any capex.

This is why so many fast-growing service businesses run out of cash despite strong P&L numbers. The income statement records revenue when invoiced, but the cash to pay subcontractors and payroll has to leave the bank now. The mismatch is the working-capital gap, and closing it requires either deposits up front, faster collections, slower disbursements, or a line of credit sized to the gap.

Net working capital is reported on the balance sheet, but the operating subset — receivables + inventory + WIP − accounts payable − accrued expenses — is what actually moves with the business. Track this number monthly and as a percentage of trailing-twelve-month revenue; if the percentage is rising, the business is becoming more cash-hungry per dollar of growth.

Watch the working-capital footprint of your largest customers carefully. A single customer extending payment from net-30 to net-60 across a $1M annual revenue base requires an extra ~$80k of working capital — a real cash event that requires either a line draw or a deposit conversation. Customer concentration is also working-capital concentration in disguise.