The Business That Made a Profit and Still Went Under
Here is a scene we have watched play out more than once. A business has a great year. Sales are up, the profit and loss account shows a healthy figure, and the owner is rightly pleased. Then a supplier invoice lands, the VAT bill is due the same week, and there is not enough in the bank to cover both. A profitable company, scrambling for cash.
This is the gap between profit and cash, and the thing that lives in that gap is working capital. Profit is a number on a report. Working capital is whether you can actually pay your bills this month. The two are related, but they are not the same, and confusing them is one of the quietest ways a growing business gets into trouble.
This guide explains what working capital is in plain English, shows the formula with a worked example, walks through the cycle that ties up your cash, and sets out what you can actually do to free some of it up.
What Working Capital Actually Means
Working capital is the money a business has available to run its day to day operations. It is the cushion between the short-term things you own and the short-term things you owe.
The formula is short:
Working capital = current assets − current liabilities
Both of those terms come straight off the balance sheet, so working capital is not a separate report you produce. It is a number you read out of figures you already have.
Current assets are things you own that will turn into cash within about a year. The main ones are:
- Cash in the bank
- Trade receivables, the money customers owe you
- Stock or inventory waiting to be sold
- Prepayments, costs paid in advance
Current liabilities are things you owe and will have to pay within about a year:
- Trade payables, the money you owe suppliers
- VAT and PAYE owed to HMRC
- Short-term loans and overdrafts
- Accruals, costs you have used but not yet been billed for
Notice that fixed assets like buildings, vehicles and machinery do not appear here. They matter to the business, but you cannot sell the delivery van to pay Tuesday's wages, so they sit outside the working capital calculation. The same goes for long-term loans. If our separate guide on depreciation covers how fixed assets lose value over time, working capital is about the opposite end of the balance sheet: the fast-moving money.
A Worked Example
Numbers make this concrete. Take a small wholesale business at its year end.
Current assets:
- Cash: £8,000
- Trade receivables: £22,000
- Stock: £18,000
- Total current assets: £48,000
Current liabilities:
- Trade payables: £25,000
- VAT due: £6,000
- Overdraft: £5,000
- Total current liabilities: £36,000
Working capital is £48,000 − £36,000 = £12,000.
That £12,000 is the buffer. It is what stands between the business and the moment it cannot pay something on time. On its own the figure means little, which is the point most explanations miss. £12,000 is comfortable for a business with £200,000 of annual sales and dangerously thin for one turning over £2 million. Working capital is always read in the context of how much cash the business burns through.
Net Working Capital and the Working Capital Ratio
You will see the term net working capital used a lot. In practice it means the same thing as the formula above: current assets minus current liabilities. The word "net" is just there to stress that you are looking at the difference between the two, not the size of either one. Some textbooks call the total current assets "gross working capital", but you will rarely need that distinction in a real business.
More useful is turning the subtraction into a ratio:
Working capital ratio = current assets ÷ current liabilities
In our example that is £48,000 ÷ £36,000 = 1.33. The business has £1.33 of short-term assets for every £1 of short-term debt. This is the same thing as the current ratio you may have met in the balance sheet guide.
As a rough guide, a ratio comfortably above 1.0 means the short-term assets cover the short-term debts. Below 1.0 means they do not, and cash flow is likely to be tight. A ratio that has climbed very high, say above 2.5 or 3, is not automatically good news either. It can mean cash is sitting idle, stock is piling up, or customers are taking far too long to pay. A ratio is a prompt to ask a question, not an answer on its own.
The Working Capital Cycle: Where Your Cash Goes to Hide
The single most useful idea here is the working capital cycle, sometimes called the cash conversion cycle. It is the journey a pound takes from leaving your bank account to coming back, and the longer that journey, the more cash the business needs to keep the lights on.
Follow a pound through a typical trading business:
- You pay a supplier for stock. Cash goes out.
- The stock sits on the shelf or in the warehouse for a while.
- You sell it to a customer on credit. Now it is a trade receivable, not cash.
- The customer eventually pays. Cash comes back in.
The gap between step 1 and step 4 is the cycle. If you pay suppliers in 30 days, hold stock for 40 days, and customers take 50 days to pay, your cash is tied up for a long stretch before it returns. Every pound of sales growth stretches that gap wider, which is the mechanism behind the profitable business that runs out of money. Growth eats cash, because you have to fund the next batch of stock and the next round of customer credit before the last one has paid you back.
This is why we keep saying that the danger is invisible on the profit and loss account. The P&L records the sale the moment you make it. The bank account only sees the money 50 days later. Reading the two together, alongside trade receivables and trade payables, is the only way to see the squeeze coming.
Positive, Negative and Why Negative Is Not Always Bad
Most owners assume positive working capital is good and negative is bad. Usually true, but not always, and the exception is worth understanding.
Positive working capital means current assets exceed current liabilities. The business can meet its short-term obligations from its short-term assets. For the great majority of small UK businesses, this is what you want.
Negative working capital means current liabilities exceed current assets. For most businesses this is a warning sign that they are funding day to day operations with money they owe and may struggle to pay. But a handful of business models run on negative working capital quite deliberately and very successfully. Supermarkets are the classic case. They take cash from customers at the till instantly, yet pay their suppliers 60 or 90 days later. They are funding their entire operation using their suppliers' money, and that is a strength, not a weakness, when it is by design.
So negative working capital is not automatically a crisis. The question is always the same: is this the natural shape of the business model, or is it a sign that the bills are about to outrun the bank? For a wholesaler or a manufacturer, negative working capital is a red flag. For a business that takes payment upfront, it can be perfectly healthy.
How to Free Up Trapped Working Capital
When a business feels cash-tight despite trading well, the cash is almost always trapped in one of three places. Each has a lever.
Get paid faster. Tighten the terms on your trade receivables. Invoice the day the work is done rather than at month end. Make payment easy, chase politely but promptly, and consider deposits or staged billing for larger jobs. Knocking ten days off how long customers take to pay can transform a cash position.
Hold less stock. Stock is cash sitting still. Money tied up in goods on a shelf is money that cannot pay wages. Ordering smaller amounts more often, clearing slow-moving lines and watching what genuinely sells all release cash, though they need to be balanced against the risk of running out.
Pay suppliers on terms, not early. Using the full credit period your suppliers offer is sensible cash management, as long as you stay inside the agreed terms and protect the relationship. Paying a 60-day invoice on day 5 for no reason is handing over your cash buffer for nothing.
The art is doing all three at once without straining your customer relationships, your supplier goodwill or your ability to fulfil orders. That balance is different for every business, which is why working capital is a management conversation, not a one-off calculation.
Our View: Forecast It, Do Not Just Measure It
In our experience, the businesses that handle working capital well are not the ones with the biggest cushion. They are the ones that look forward rather than back.
A working capital figure from your year-end accounts is a photograph of a single day, months ago. Useful, but it tells you where you were, not where you are heading. The owners who avoid the cash crunch are the ones running a simple rolling cash flow forecast: what is due in, what is due out, and what the bank balance will be in six and twelve weeks. That forward view is where a working capital squeeze shows up early enough to do something about it, whether that is chasing a slow payer, delaying a purchase or arranging a facility before you need it rather than in a panic.
Profit is an opinion formed once a year. Cash is a fact that has to be true every single week. Working capital is simply the bridge between the two, and the businesses that respect that distinction are the ones still standing after a tough quarter.
How IAK Can Help
We help owners see their working capital before it becomes a problem. Clean bookkeeping keeps the receivables, payables and stock figures accurate, management reporting turns those figures into a monthly view of the cycle, and our accounting work ties it all back to a set of year-end accounts you can trust.
If the gap between your profit and your bank balance has ever caught you out, that is exactly the gap we help close. Contact us for a straight conversation about your numbers.
Sources
- Companies Act 2006, balance sheet formats and the split between current and fixed assets and liabilities. See the GOV.UK annual accounts guidance.
- FRS 102, the financial reporting standard most UK small and medium companies use, sets out how current assets and current liabilities are classified. Published by the Financial Reporting Council.
- The British Business Bank publishes practical guidance for smaller firms on managing working capital and cash flow.