In March 2020, a restaurant group in London was fully booked for the spring season. Revenue was projected to be their best year yet. On paper, the business looked healthy. Accounts receivable were solid, inventory was stocked, and the books showed profit from the previous quarter.
Then lockdown hit.
Within six weeks, they could not cover rent. Not because the business was failing long-term. Because they did not have enough short-term cash available to stay alive while waiting for conditions to change. Their current liabilities outweighed their current assets by a wide margin.
That gap has a name: working capital.
The formula, kept simple
Working capital is the difference between what a business owns in the short term and what it owes in the short term.
Working Capital = Current Assets - Current Liabilities
Current assets are everything the business can turn into cash within 12 months: cash in bank accounts, accounts receivable (money customers owe you), and inventory. Current liabilities are everything due within 12 months: accounts payable, short-term loans, wages payable, accrued expenses, and taxes owed.
If current assets are greater than current liabilities, the business has positive working capital. Cash is available, bills can be paid, the business keeps moving.
If current liabilities exceed current assets, the business has negative working capital. That is when things get tight, borrowing increases, and suppliers start calling.
A real example to make it concrete
A small manufacturing business runs these numbers at the end of the quarter:
| Current Assets |
Amount |
| Cash |
$40,000 |
| Accounts Receivable |
$85,000 |
| Inventory |
$60,000 |
| Total Current Assets |
$185,000 |
| Current Liabilities |
Amount |
| Accounts Payable |
$70,000 |
Short-term Loan
Repayment |
$30,000 |
| Wages Payable |
$25,000 |
| Total Current Liabilities |
$125,000 |
Working Capital = $185,000 - $125,000 = $60,000
That $60,000 is the buffer. If a major customer delays payment by 60 days, or inventory costs spike unexpectedly, that buffer absorbs the blow. Without it, the business would need emergency financing or start missing payments.
The working capital ratio: a quicker read
Beyond the dollar figure, accountants also calculate the current ratio (also called the working capital ratio). The formula divides rather than subtracts:
Current Ratio = Current Assets / Current Liabilities
Using the same numbers above: $185,000 / $125,000 = 1.48
Here is what that ratio typically signals:
| Current Ratio |
What It Means |
| Below 1.0 |
Current liabilities exceed assets. Cash flow risk is high. |
| 1.0 to 1.2 |
Very thin margin. One bad month can cause problems. |
| 1.2 to 2.0 |
Healthy range. The business can meet obligations and absorb surprises. |
| Above 2.0 |
Either very safe or too much cash sitting idle instead of being deployed. |
A ratio between 1.2 and 2.0 is the target for most businesses. Service businesses can operate comfortably at the lower end since they carry little inventory. Retailers and manufacturers need more buffer because cash sits locked inside stock before a single sale happens.
Why profitable businesses still run out of cash
This is the part that confuses most people: a business can be profitable and cash-poor at the same time.
Profit is an accounting number. Working capital is a timing problem.
Take a construction firm that wins a $500,000 contract. They buy materials, pay workers, and carry the project for four months before the client pays. During those four months, profit exists on the income statement. Cash does not exist in the bank. If their current liabilities come due during that window, and their working capital buffer is thin, the business cannot make payroll. The profit they recorded means nothing in that moment.
This is why working capital deserves attention every single month, not just at year-end.
Three ways to improve working capital without borrowing
Speed up receivables
Send invoices the day work is completed. Offer a 2% early payment discount if customers pay within 10 days instead of 30. Every day an invoice sits uncollected is a day that cash is not in the business.
Slow down payables (within reason)
Negotiate 45 or 60-day payment terms with suppliers if the current terms are 30. The longer cash stays in the account, the higher the working capital buffer. This only works if relationships with suppliers are strong and payments are still made on time.
Reduce inventory levels
Holding excess inventory is holding cash in a warehouse. Running a quarterly review of slow-moving stock and clearing it frees up working capital without taking on a single cent of debt.
The number to track every month
Pull the balance sheet at the end of each month. Add up current assets. Subtract current liabilities. Watch the trend. If working capital is shrinking across three consecutive months, something in the cash conversion cycle needs fixing before the buffer disappears entirely.
A useful benchmark: working capital should cover at least 20 to 35 percent of annual gross revenue. A business generating $400,000 a year should carry $80,000 to $140,000 in working capital. That buffer covers two to three months of operating expenses without touching a credit line.
The restaurant in London survived, eventually. But they spent two years paying off emergency debt they took on in those first six weeks. A working capital buffer of even $80,000 would have changed that outcome completely.
Track the number. Fix the trend early. Businesses that fail are rarely the ones that ran out of customers. They are the ones that ran out of time while the cash was still on its way.
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