Finance

What is Working Capital?

Working capital is the heartbeat of any business. Learn how to manage it smartly to keep operations smooth, reduce risks, and fuel long-term growth.

Team Dhan

08 Aug 2025 — 4 min read

Photo by Jakub Żerdzicki / Unsplash

Behind every successful business is a strong grip on financial basics—yet these are often ignored. In 2024, an ICAI report revealed that over 80% of Indian MSMEs struggle with liquidity because of poor cash flow. This highlights the importance of one simple yet powerful concept: working capital. It may sound basic, but it’s the backbone of daily operations and long-term stability. Businesses with a healthy working capital cycle can steer clear of short-term debt and keep things running smoothly.

In this guide, we’ll break down what working capital really means, how to calculate it, why its components matter, and practical ways to improve it so your business stays financially strong.

Working capital explained in simple terms

Working capital is basically the money a business has left after paying off what it owes in the short term. It’s calculated as:

Working Capital = Current Assets – Current Liabilities

Think of it as a quick health check for your business’s finances. If the number is positive, it means you have enough liquid or easily convertible assets (like cash, receivables, or inventory) to cover your day-to-day expenses without taking on extra debt. In short, it shows how comfortably your business can keep running and meet its short-term needs.

Formula of Working Capital

Here’s how you can break down the working capital formula:

Component	What It Includes
Current Assets	Cash, accounts receivable, inventory, marketable securities, prepaid expenses
Current Liabilities	Accounts payable, short-term loans, accrued expenses, taxes payable
Working Capital	Net result when you subtract liabilities from assets – ideally, a positive number

For example, if a business has ₹10 lakh in current assets and ₹6 lakh in current liabilities, then:

Working Capital = ₹10,00,000 – ₹6,00,000 = ₹4,00,000

This positive working capital indicates the business can comfortably cover short-term expenses.

An example

Let’s take a simple example to show how working capital is calculated:

Item	Amount (₹)
Cash	1,00,000
Inventory	4,00,000
Accounts Receivable	3,00,000
Accounts Payable	2,50,000
Short-term Loans	1,00,000
Net Working Capital	4,50,000

TWorking Capital = (1L + 4L + 3L) - (2.5L + 1L) = ₹8L – ₹3.5L = ₹4.5L

This indicates good liquidity and operational stability.

The components

Understanding the key parts of working capital helps you manage it better:

Component	Description
Cash and Cash Equivalents	Money that a business can use right away to pay for daily expenses.
Accounts Receivable	Money that is owed to the company by customers. The quicker it can be received, the greater the impact on working capital.
Inventory	Goods that are available for sale. Efficient inventory management ensures products are sold quickly, preventing cash from getting tied up in unsold stock.
Accounts Payable	Money owed to vendors. Better management can improve your working capital.
Short-term Debt	Refers to loans or borrowing that are payable within a year. Lower short-term debt raises the working capital ratio.

The importance

Working capital plays a big role in keeping a business running smoothly and helping it grow.

Keeps things moving: With enough working capital, you can pay salaries, rent, and suppliers on time without breaking a sweat.
Builds trust: A healthy working capital reassures lenders and investors that your business can access funds when needed.
Cuts down money stress: You’re less likely to rely on costly short-term loans or scramble for cash during tough times.
Fuels growth: It gives you the freedom to invest in marketing, stock up on inventory, or develop new products without worrying about running out of funds.

What is negative Working Capital?

Negative working capital occurs when current liabilities exceed current assets. This can be risky unless the business has a quick inventory turnover and strong cash flow.

Scenario	Interpretation
Negative working capital for a standalone retail store	It may be feasible to sell stock, such as groceries, quickly.
Negative working capital in a startup	This typically indicates cash flow issues and businesses being in trouble.

How to improve Working Capital?

Managing your working capital well can keep your business running smoothly and set it up for long-term growth. Here are some practical ways to do it:

Speed up payments coming in: Offer small discounts for early payments and follow up regularly on overdue invoices.
Avoid inventory pile-ups: Use smart demand forecasting tools to keep stock levels just right — not too much, not too little.
Take more time to pay suppliers: Negotiate longer payment terms without damaging your relationship with them.
Cut the extras: Trim unnecessary costs that don’t impact the quality of your product or service.
Go digital: Use tools that give you real-time insights into cash flow, expenses, and investments. Some even offer low brokerage, helping traders and small businesses use their capital more efficiently.

The limitations

While working capital is a handy measure of a company’s financial health, it’s not perfect. Here’s why you shouldn’t rely on it alone:

Only shows the short-term picture: It tells you how the business is doing right now, but not whether it can survive and grow in the long run.
Numbers can be misleading: A company might look weak on paper because of slow-moving stock or overdue customer payments, even if its core business is strong.
Varies by industry: Different sectors have different needs. For example, manufacturing businesses require more working capital than a service-based company.

Why Working Capital knowledge matters

Whether you’re a finance manager, entrepreneur, or investor, understanding working capital is key to keeping a business flexible, strong, and ready to grow. Knowing how to calculate it, manage its key parts, and spot early warning signs helps you prepare for challenges and grab opportunities when they come. In short, smart working capital management can be the difference between simply surviving and truly thriving.