Back to Blog
If you’re a small business owner, you know how crucial it is to keep your finances in check. But here’s the thing — understanding working capital vs. cash flow can be a bit like deciphering a foreign language. These two terms might sound similar, but trust me, they each tell a completely different story about your company’s financial health.
What’s the deal with working capital?
At its core, working capital is a measure of how much operating money you have left over after your debts are covered. It’s not just the cash sitting in your account — it includes assets like equipment, investments, and inventory. On the flip side, it also considers liabilities such as accrued expenses, accounts payable, short-term debt, and long-term obligations.
Working capital is a short-term measure — typically evaluated over the course of a year — and it tells you if you can handle the daily grind of business expenses. For example, if your clients are delayed on payments because of a natural disaster, your working capital might be the lifeline that keeps you afloat until they catch up.
What about cash flow?
Cash flow, on the other hand, is all about the movement of money in and out of your business over a set period of time. It gives you a broader picture of your finances. Essentially, it tracks how much money is coming in from sales and how much is going out toward expenses. If your cash flow is positive, it means your business is generating enough revenue to cover its operating costs, pay bills, and possibly even reinvest in growth.
Unlike working capital, cash flow doesn’t include long-term assets or liabilities. It’s purely about income and expenses, and it’s a critical indicator of whether your business is generating enough revenue to survive, especially in the short term.
The key differences: Working capital vs. cash flow
The main difference between working capital and cash flow lies in their scope and the type of financial information they provide.
- Working capital gives you a snapshot of your ability to cover immediate debts with your short-term assets. It’s like checking how much cash you have on hand to keep things running day-to-day.
- Cash flow looks at the broader picture — how much money your business is generating and spending over time. It’s your overall financial health barometer.
So, why does this matter? Well, cash flow can fluctuate, but working capital gives you the security that you’ll have enough to cover your debts in case of an emergency. In other words, while positive cash flow means your business is in the green, positive working capital ensures you can manage all the curveballs life throws your way.
Crunching the numbers: Current ratio and quick ratio
To get a solid sense of your working capital, you can look at two key ratios: the current ratio and the quick ratio.
The current ratio measures your company’s ability to pay both short-term and long-term liabilities. To calculate it, simply divide your current assets by your current liabilities. A ratio of 1 or above is typically considered good.
Example:
Let’s say Connor’s Contracting has $300,000 in current assets and $100,000 in current liabilities. The current ratio would be:
Current ratio = Current assets ÷ Current liabilities
Current ratio = $300,000 ÷ $100,000 = 3
A ratio of 3 means Connor’s Contracting is in solid financial shape and can handle any short-term bumps.
The quick ratio is a more conservative measure. It excludes inventory from the equation, as inventory can be harder to convert into cash quickly. It’s a stricter measure of liquidity.
Example:
Connor’s Contracting has $300,000 in current assets, $100,000 in liabilities, and $200,000 in inventory. The quick ratio would be:
Quick ratio = (Current assets – Inventory) ÷ Current liabilities
Quick ratio = ($300,000 – $200,000) ÷ $100,000 = 1
This tells us that without counting inventory, Connor’s Contracting still has a solid financial footing.
When working capital affects cash flow
A business can have positive cash flow but still struggle with working capital if its liabilities outweigh its assets. If your working capital is negative, even a healthy cash flow might not be enough to cover your immediate financial obligations.
If your company is running with negative working capital, it could mean trouble. You might have positive cash flow from sales, but if you’re constantly using your cash to cover short-term liabilities, you won’t have enough room to manage unforeseen expenses. Lenders are particularly concerned about businesses with negative working capital, as it signals higher risk. They’ll take a close look at your working capital and cash flow before extending any loans.
At Forwardly, we make it easy to stay on top of your cash flow management. We’ve got your accounts receivable and accounts payable streamlined so smoothly, that you’ll wonder why you ever let them be a chaotic mess in the first place.
Ready to take control of your cash flow? Get started with Forwardly today and watch your financial stress melt away.
