In the early stages of a startup, founders often obsess over two numbers. The first is revenue. The second is the bank balance. While these are important, they do not tell the full story of your company’s immediate health. To understand that, you need to understand Working Capital.
Working capital is the difference between a company’s current assets and current liabilities. It is a measure of your operating liquidity. It represents the money you have available to meet your short-term obligations and keep the business running day-to-day.
The formula is deceptively simple: Current Assets minus Current Liabilities equals Working Capital.
However, interpreting this number is where many businesses fail. You can be profitable on paper and still go bankrupt if you run out of working capital.
The Gap Between Sales and Cash
#Profit is not the same as cash. This is the hardest lesson for new entrepreneurs to learn.
Imagine you run a hardware startup. You receive a massive order from a retailer for $100,000. Your cost to make the goods is $60,000. You have a $40,000 profit. This looks great on an income statement.
The problem is the timeline. You have to pay $60,000 now to manufacture the goods. The retailer might not pay you for 90 days. During those three months, your working capital takes a massive hit. You have to pay rent, salaries, and server bills while waiting for that revenue to arrive.
Working capital is the bridge that carries you over that gap. If the bridge is too short, the company falls into the abyss.
Current Assets vs. Liabilities
#To calculate this accurately, you need to know what counts as “current.” In accounting terms, current means anything that can be liquidated or must be paid within 12 months.
Current Assets include:
- Cash in the bank
- Accounts Receivable (money customers owe you)
- Inventory (goods waiting to be sold)
Current Liabilities include:
- Accounts Payable (money you owe suppliers)
- Short-term debt payments
- Accrued liabilities (like wages owed)
If your liabilities exceed your assets, you have negative working capital. This implies you may have trouble paying off debts. If you have excessive positive working capital, it might mean you aren’t investing your cash aggressively enough.
Working Capital vs. Funding
#It is important to distinguish working capital from investment capital (like Seed or Series A funding). Investment capital is usually intended for long-term growth initiatives, such as R&D or entering new markets.
Working capital is for operations. Ideally, a mature business should generate enough working capital from its own cycles to survive. However, high-growth startups often burn through working capital because growth is expensive. Buying inventory for next year’s growth consumes today’s cash.
Managing the Cycle
#Optimizing working capital is a lever you can pull to extend your runway without raising more equity.
This involves managing your “Cash Conversion Cycle.” Can you get customers to pay you upfront? Can you negotiate longer payment terms with your vendors? If you can collect money in 30 days but pay your vendors in 60 days, you are using other people’s money to fund your operations.
Founders need to ask themselves if they are acting as a bank for their customers. If you are, you need the balance sheet to support it.