The Financial Thermometer of Your Business

A company’s financial health is often measured by its working capital. This crucial metric acts as a business “thermometer,” providing a glance at a company’s financial stability and operational efficiency. But what exactly is working capital, and why is it so important? 

Working capital is the difference between a company’s current assets and liabilities, as reported on the balance sheet.

Current assets include cash, accounts receivable and inventory – essentially, anything that can be converted into cash within a year. Current liabilities, on the other hand, are obligations the business expects to pay within the same period, such as vendor payments, employee wages and short-term debts. 

Think of net working capital as a revealing indicator of a company’s ability to weather financial storms. A positive net working capital means a business has sufficient resources to invest and grow. Conversely, a negative balance could be a red flag, signaling potential financial distress. 

Key Components of Working Capital 

As working capital is dependent on a business’ complete operating cycle, it is crucial to regularly and consistently review and analyze this metric. To do so, it is beneficial to examine the following metrics individually to identify any conditions and trends that may impact the company’s working capital conditions and profitability. 

  • Accounts Receivable: A fundamental objective of any business should be to convert sales to cash as quickly after the sale as possible. Some businesses, either by nature or company policy require cash upon delivery or, sometimes, even in advance. For businesses that extend credit to customers, there are three fundamental questions to answer regarding managing their accounts receivable: 
    1. How soon, after the sale, are you collecting the amounts owed to you by your customers? 
    2. Are your receivables generally increasing, decreasing or remaining constant as a percentage of total sales? 
    3. Are any receivables unlikely to be collected without expending significant resources (e.g., legal fees)? 

To answer these questions, you should routinely review the customer’s accounts receivable aging report to identify any delinquent payments beyond the terms extended to them. 

  • Inventory: Efficient inventory management is crucial for a company’s profitability and cash flow. It’s comparable to Goldilocks’ story, where too much inventory ties up cash and increases the risk of obsolescence if it cannot be sold within the company’s regular operating cycle. On the other hand, too little inventory leads to missed sales and dissatisfied customers. The ideal level of inventory is the one that can be sold at list price within a specific time frame that best matches the company’s operating cycle. 
  • Trade Accounts Payable: In an ideal scenario, a company’s payment to its vendors would align perfectly with the sale and collection of its products and services from its customers. This would help maintain positive working capital and ensure a healthy financial state of the business. But this can be difficult to achieve. A reasonable objective is to adhere to this standard as closely as possible. There are some guidelines that all businesses should keep in mind to benefit from:  
    • Do: 
      • Take advantage of purchasing discounts if they are available. 
      • Pay vendor invoices early if they offer incentives to do so. 
      • Buy in bulk when prices are expected to increase. 
    • Don’t: 
      • Purchase too far in advance of your expected sales cycle. 
      • Pay too much. 
      • Buy items that are at risk of becoming obsolete. 
      • Pay invoices earlier than your vendor’s required terms, unless there is a financial incentive to do so. 
  • Short-term Financing: Short-term financing from sources such as traditional lenders, finance companies and even credit cards can be an important part of your cash flow management. Operating lines of credit are usually available from conventional lenders and can often offer the most competitive rates of interest and repayment terms. If managed effectively, short-term financing helps to bridge the gap between the sale and collection of business goods and services and the repayment to trade vendors and suppliers. Like all objectives concerning working capital management, the key is to structure your short-term borrowing and repayments with your sales and collections cycle. 
  • Long-term Financing: If the servicing of your long-term debt is causing you to erode a company’s positive working capital significantly, it’s possible that restructuring the debt toward a longer maturity and better interest rates is merited. That portion of your long-term debt principal is considered “current,” which equals the required principal amount to be paid back within the next 12 months. If this amount is greater than a business’s net positive working capital can accommodate, then restructuring may be necessary. 

Industry Benchmarks & Ratios 

Understanding industry benchmarks, such as the working capital ratio, provides insight into how a company stacks up against its peers. This ratio, calculated by dividing current assets by current liabilities, offers a quick look at a company’s ability to meet short-term obligations. 

A variation of this ratio is the “quick” ratio which modifies current assets by excluding illiquid items such as inventory or prepaid expenses. Both ratios attempt to give a fast, insightful measurement into a company’s financial liquidity, operating performance and profitability, and its ability to meet its financial obligations and provide a return to its investors. 

Industry benchmarks are compiled and published by several sources, such as the Risk Management Association (RMA) or Dun Bradstreet. 


Working capital is more than just a number on a balance sheet. It’s a vital sign of your company’s financial health and operational efficiency. Regularly reviewing and managing working capital components ensures your business is not just surviving, but thriving.

So, ask yourself: Is your working capital working for you? 

If you have questions on ways your company should use or calculate working capital, contact an Adams Brown advisor.