Working Capital vs. Cash Flow: How They Are Related

Last Updated October 10, 2024

When it comes to keeping your business financially healthy, two of the most important terms to understand are working capital and cash flow. However, new business owners might not understand the differences between them.

While working capital does influence cash flow and vice versa, they are each their own distinct measurement, so it’s pivotal to have a clear understanding of their differences.

By understanding what they are, how to measure them, and how to improve both working capital and cash flow, you can better secure a stable financial future for your business.

What Is Working Capital?

Working capital is a term that measures the difference between your company’s current assets and its current liabilities. Assets include cash on hand as well as other financial resources that could be easily liquidated for cash, such as investments, office equipment, and inventory. Current liabilities include your business’s accounts payable, payroll taxes, and other outstanding expenses.

Why Is Working Capital Important?

Working capital is considered an important measure of financial health, usually used to determine a business’s outlook for the next 12 months, with a specific focus on its ability to weather unexpected financial setbacks. Such setbacks could include supply chain issues, new tech that disrupts your market, or an unexpected decrease in sales because of a successful new competitor.

A positive working capital indicates that a company would be well-positioned to fulfill its short-term financial obligations.

How Do You Measure Working Capital?

Knowing how to measure working capital is important — and fortunately, the process is fairly straightforward.

The basic formula for measuring your working capital is:

Current Assets – Current Liabilities = Working Capital

Current assets include cash, as well as highly liquid assets that can easily be converted to cash (considered “cash equivalents”), such as accounts receivable, investments, inventory, and business equipment. Your current liabilities will include all short-term debt and accounts payable, as well as payroll taxes and notes payable.

While measuring your total working capital will tell you whether you have positive or negative working capital, measuring the current ratio can also be helpful in understanding the overall financial health of your business.

Current Assets / Current Liabilities = Current Ratio

A 1.0 ratio means your assets are equal to your liabilities.

Wondering how much working capital you need? Aiming for a ratio between 1.5 and 2.0 ensures you have enough working capital to manage your debts and use assets toward other growth goals.

How to Improve Working Capital

If your working capital is negative, this doesn’t mean your business is doomed — there are many actions you can take to improve working capital, particularly in regard to invoicing. Sending invoices quicker, collecting payments on time, shortening your payment terms and implementing late fees and early payment discounts can all improve your invoicing process. For small business owners in particular, invoice factoring can also improve accounts receivable.

Businesses can additionally improve working capital through more efficient inventory management and negotiating more favorable payment terms with vendors. Leasing equipment instead of buying it can also leave more working capital available for other uses.

What Is Cash Flow?

Cash flow is an easier concept for most business owners to understand, since it simply measures how much cash moves in and out of a business during a set period of time (this could be a week, month, quarter, or even year).

Why Is Cash Flow Important?

Measuring cash flow helps you determine whether your business is earning more than it is spending during a particular time, or vice versa. When you have positive cash flow, you have the financial means to cover all expenses, invest more in the business and grow your operations.

When you have a negative cash flow, it means that your spending is eating into your cash reserves. It isn’t unusual for companies to experience periods of negative cash flow (especially for seasonal businesses whose sales fluctuate throughout the year or new businesses). However, extended periods of negative cash flow can eventually cause the business to run out of money entirely. In fact, poor cash flow management is linked to 82% of business failures.

How Do You Measure Cash Flow?

Knowing how to measure cash flow is essential for keeping your company’s finances in the black. The easiest way to accomplish this is by regularly drafting a cash flow statement. Remember, this statement can cover the period of your choosing, such as a single calendar month or a quarter.

Start by recording your opening balance — or how much balance was in your business bank account at the start of the period you’re measuring for the cash flow statement. To measure net cash flow, you’ll then calculate cash inflows and outflows for this period, only measuring the money that goes in or out of your business bank account.

This means, for example, that you would only include invoices that have been paid by clients — not invoices that are still outstanding. At the end of the tracking period, you can see how much cash is left in your business bank account and compare it to the amount that was present at the beginning of the period.

The simplest way to measure net cash flow is:

Total Cash Inflows vs. Total Cash Outflows = Cash Flow

Keep in mind that while this net cash flow formula is a great way to analyze business performance, there are other types of cash flow, including incremental cash flow, operating cash flow, investing cash flow, and financing cash flow, with slight variations in how to measure each type.

Taking a deep dive into why and how money enters and exits your accounts is essential for improving cash flow.

You can also calculate your cash flow margin to determine the profitability of your operating activities by dividing the total cash flow from your operations by your net sales. This can also help you track changes in profitability over time.

How to Improve Cash Flow

By tracking cash as it moves in and out of your accounts, you can better understand how your business is getting paid and how it is spending money — and subsequently identify areas for improvement.

Many of the practices to improve cash flow are actually similar to those designed to improve working capital. Methods such as invoice factoring, offering early payment discounts, or shortening payment terms will accelerate the amount of cash being funneled into your business.

Of course, you can also improve cash flow by increasing prices, liquidating less popular items at a discount to reduce inventory, renegotiating vendor contracts, and cutting unnecessary expenses. Be sure to consider the long-term impact of such actions — after all, you don’t want to lose the bulk of your customers because of a major price hike!

How Does Working Capital Affect Cash Flow?

Analyzing working capital vs. cash flow reveals that while they are clearly distinct from each other, one still heavily influences the other. Whether or not a financial transaction affects both working capital and cash flow comes down to the type of transaction being made.

For example, if you use cash to purchase additional inventory, your cash flow would decrease. However, your working capital would remain the same because inventory is considered a current asset. The categories that different working capital assets are allocated under would change, but the total amount would not.

Because of this, you shouldn’t exclusively analyze working capital or cash flow. Measuring both working capital and practicing cash flow management will equally assist you in making smarter business decisions.

In Summary: Differences Between Working Capital and Cash Flow

Let’s recap what you need to know about working capital vs. cash flow:

	Cash Flow	Working Capital
Definition	The total cash moving in and out of a business’s accounts	The sum of a business’s liquid assets, minus the total of its short-term liabilities
Why It’s Important	Tells you whether you have more money entering your accounts than what you spend during a given period	Measures your business’s ability to meet short-term obligations over the next 12 months
How To Measure	Total Cash In – Total Cash Out = Cash Flow	Current Assets – Current Liabilities = Working Capital
What It Measures	Cash balances flowing in and out of your business bank account	Whether the total value of liquid assets (cash, investments, inventory, etc) is greater or less than your short-term liabilities (accounts payable, payroll taxes, etc.)
How to Improve It	•   Invoice factoring •   Shorten invoice payment terms •   Increase prices •   Liquidate less popular inventory •   Renegotiate vendor contracts	•   Send invoices quicker and collect them on-time •   Shorten invoice payment terms •   Invoice factoring •   Implement late fees and early payment discounts •   Lease equipment instead of buying

In-Summary: The Relationship Between Working Capital and Cash Flow

Working capital and cash flow are two of the most important financial measuring sticks for a business. You’ll hear them referenced a lot, though they have very different meanings. You also don’t necessarily need to be striving for having the most working capital or the most positive cash flow possible—too much working capital or too positive of cash flow can actually be a negative sign.

Yes, you should always aim for having positive cash flow each cycle or period as that means you have more money coming in than going out. However, you should have a constant inflow and outflow of cash. If you have hordes of operating working capital but you’re not putting any of it back into your business, you’re probably not optimizing your long-term outlook. This is why it’s so helpful to regularly perform a working capital analysis to see how you can better your business

Working Capital vs. Cash Flow FAQs

Is working capital the same as cash flow?

No. Your business’s working capital compares your business’s total assets and liabilities, which can include investments, inventory and business equipment that can be liquidated for cash, as well as loans and other accrued expenses.
Cash flow, meanwhile, measures how much cash moves in and out of your business accounts during a specified period.

What is the difference between capital vs. cash?

Because capital includes investments and other physical assets, it is used to pay for long-term investments and is measured over the course of years. Operating cash is used for “standard” everyday expenses such as utilities and overhead and is often measured on a weekly or monthly basis.

What is the difference between working capital vs. free cash flow?

Working capital is measured by subtracting current liabilities from current assets. Free cash flow is measured by subtracting capital expenditures from your operating cash flow. Both are measurements of your company’s financial health, so you want them to be a positive number.