Working capital continues to go under-examined by most small businesses. First by knowing how much cash you need to run the business, and then by assessing how efficiently you deploy this cash, you can make smart decisions that spur growth. 

And it doesn’t have to be overly complicated. In this article, we’ll look first at the critical metrics you should measure, plus others that can provide serious insight. 

Most of the numbers you need to calculate these are already in your balance sheet, so the work is relatively easy. 

Let’s dive in. 

What is working capital? 

Your company’s working capital is the cash required to run the business: assets minus liabilities. That includes inventory, paying staff, rent, utilities, tools, and other necessities. What’s left over is profit to invest in new growth initiatives or save for a rainy day. 

Most accountants want to ensure working capital remains positive - that you have more assets than debts. But growing businesses can actually use negative working capital to generate net cash by selling assets faster than they repay liabilities. 

Read the story of how Gymshark used a negative cash conversion cycle to grow incredibly quickly.

Unlike most of the metrics on this list, working capital is expressed in pounds, dollars, euros, or whichever currency you prefer. It’s not a ratio - it’s the literal cash and assets you have on hand to run your business. 

Why track working capital? 

Working capital isn’t just a measure of financial health, it’s a tool SMBs can use to function efficiently. You can intentionally increase working capital when you know you want to invest heavily, or decrease it by paying off debts early.

Here are six smart ways for small businesses to optimise working capital. 

Let’s look at a few ways to measure working capital efficiency.

9 valuable working capital metrics

Here are nine working capital metrics you might want to explore. The first four are considered crucial - table stakes for any small business hoping to grow or sustain itself efficiently. 

The remaining five are interesting if you want to go further and get even more advanced with working capital. Companies with larger and more stable balance sheets may get real insight from applying some of these. 

1. Days sales outstanding (DSO)

How long is the period between a sale taking place and you receiving the cash? This ultimately depends on your payment terms.

Do you require partial payment in advance? Do you offer a one-month turnaround, or perhaps three months? 

You also need to chase overdue invoices effectively. These are a fact of doing business, and reducing your DSO may require you to re-evaluate your collections process. 

A consistently high DSO - above industry averages - suggests your processes are inefficient and you’re taking too long to get paid.

DSO = (Average accounts receivable / Average daily credit sales for the past 12 months)

Example: 

Your company made £10 million in sales in the past 12 months. The daily average is therefore £27,397 (10,000,000 / 365).

Today, if you have £2 million in accounts receivable outstanding, your DSO would be 73 days. 

Whether that’s high or not depends on your industry and your own expectations. But shortening it can’t hurt.

Note: Individual months or seasons can skew your DSO in the short term. For example, if you have an excellent month of sales, you’ll naturally have more outstanding accounts receivable than usual. This is a good thing. If you can clear those within a reasonable amount of time, you’ve done well. But until you do, your DSO will be higher than normal. Strategic CFO shows why you shouldn’t overreact to outlier months. But you should try to understand why they occur.

2. Days payables outstanding (DPO)

Conversely, this is the average amount of time it takes to pay your bills. And how you massage and optimise this period creates real financial opportunities. 

In general, you want to pay on time - but not early. The longer you wait to pay suppliers, the more cash you have available. Whereas paying early effectively reduces your working capital (because you no longer have the cash). So a high DPO is often good. 

On the other hand, your DPO could be high simply because you can’t afford to pay suppliers. Not a happy place to be. 

For some business owners, it’s safer and less stressful to pay as soon as possible. Push it too far and you can end up paying late fees or incurring more debt than you’re comfortable with. 

But if you really want to optimise working capital, the goal is a DPO longer than your DSO. 

DPO = (Average accounts payable / Trailing 12-month cost of revenue) x 365

Another name for “Trailing 12-month cost of revenue” is Cost of goods sold (COGS) for those 12 months.

Example: 

To generate your £10 million in sales in the past 12 months, you needed to spend £5 million overall. (COGS = £5 million for the past 12 months).

If your starting accounts payable balance was £1.5 million, and your AP balance ended at £1 million, then your average accounts payable for the year is £1.25 million.

DPO: (1,250,000 / 5,000,000) * 365 = 91 days. 

91 is a fairly long DPO. In this example, either you’ve negotiated favourable payment terms with your suppliers, or you may be struggling to pay your debts. 

Given the high sales and (relatively) low COGS, it looks like things are going well. 

3. Days of inventory outstanding (DIO)

This measures how long the average item remains unsold in your inventory, and is a good way of estimating your ability to generate cash quickly. 

Because inventory is an asset but not cash, the faster you can sell items, the better. 

DIO can be applied to the entire inventory, or to specific products. Clearly, if certain items have a much longer DIO than the overall average, they’re proving harder to sell. 

Stock fewer of these products in reserve, and avoid tying up working capital.

DIO = (Average inventory / Trailing 12-month cost of revenue) x 365

Example:

You have £150,000 in stock at the beginning of the year, and £100,000 at the end. This makes your average inventory £125,000.

Your trailing 12-month cost of revenue (COGS) is still £5 million. 

DIO: (125,000 / 5,000,000) x 365 = 9 days.

A DIO of nine days is another indicator that this business is very efficient with working capital. 

But the next metric will really tell the full story. 

4. Cash conversion cycle (CCC)

Your cash conversion cycle is the number of days it takes your company to convert money out into money coming back in. You add your DSO (customer payment terms) to your DIO (days in inventory), then subtract your DPO (how quickly you pay suppliers). 

The goal is to have this number as small as possible - even negative. In fact, a negative cash conversion cycle suggests serious growth.

Your CCC is arguably the most important working capital metric. Focus on getting this number down, and your business should soar.

CCC = DSO + DIO - DPO

Example:

Based on the previous three sections, you have:

• A DSO of 73 days

• A DPO of 91 days

• A DIO of 9 days

CCC: 73 + 9 - 91 = minus 9 days

In other words, money is coming in faster than it’s going out. Thanks to those supplier payment terms, you should be able to fund new growth.

The four metrics above are crucial to get a clear picture of your cash situation. Let’s explore other factors that, while not as critical, help you analyse your business effectively. 

5. Current ratio

Current ratio compares your current assets with your current liabilities. Sometimes known as your “working capital ratio,” it’s a very clear way to measure company liquidity. 

“Current” assets in this case means assets that are likely to be liquidated in the next year. That includes cash, receivables, and inventory - but only if they’re likely to become liquid within 12 months. 

Current ratios are best considered by comparing with the industry average. A low ratio suggests you may be in distress or approaching default, while a high ratio indicates a business with good liquidity.

Current ratio = Current assets / Current debts

Example:

If you have current assets worth £5 million, and current debts worth £4 million, your current ratio is 1.25. 

A ratio above 1 means you have the assets available to pay off your debts. For most small businesses, this is a healthy place to be. But you may be comfortable with a ratio below 1 where you’re borrowing to invest in programs or products that you’re confident will bring a strong return. 

6. Quick ratio

Like the current ratio, the quick ratio is a measure of liquidity that pits assets against liabilities. But in this formula, you only use your most liquid assets: cash, accounts receivable, cash equivalents, and securities. These assets can be used to pay off debts quickly.

This notably excludes inventory, as those goods haven’t been sold yet. 

Again, ideally your quick ratio will be above 1. This means you’re ready to pay off debts whenever required. 

Quick ratio = “Quick” assets / Current liabilities

Example:

Your company has £4 million in cash, receivables, and securities, and still has £4 million in debts. Your ratio is exactly 1. 

7. Accounts receivable turnover

This ratio represents the number of times in a stated period that your company collected its average AR balance. It’s a direct measure of how efficient your receivables process is.  

AR turnover = Net credit sales / Average accounts receivable

Net credit sales obviously excludes up-front cash payments - these aren’t receivables. 

And we use net sales to factor in discounts and other incentives. These help get cash in more quickly, but also eat into profit. There’s a point where this becomes inefficient, which will be reflected in your ratio. 

Example: 

We saw above that your daily average sales were £27,397 (10,000,000 / 365). Let’s assume that all of these are receivables, and no discounts were offered. 

You had £1.5 million in accounts receivable outstanding at the start of the year, and £1 million at the end. The daily average is therefore £3,425.

AR turnover ratio = 8. This means you convert receivables to cash 8 times per year. 

Whether 8 is a high ratio will depend on your industry and past performance, but your overall goal should be to keep increasing that number (and keep cash coming in). 

Note: Whether you use daily figures (as above), monthly, or yearly, the turnover ratio should be the same.

8. Inventory to working capital ratio

This shows you the amount of total working capital dedicated to unsold stock. Generally speaking, a ratio of less than 1 implies that your business is highly liquid - that you turn inventory into cash efficiently.

Clearly the less working capital you have tied up in unsold inventory, the better.

Inventory to working capital = Inventory / Working capital

Example:

Your balance sheet shows £800,000 spent on inventory (an asset). You have £200,000 in accounts receivable, thus your total assets are £1 million. 

If your liabilities are £500,000, your working capital would also be £500,000. 

Inventory to working capital ratio = 800,000 / (500,000) = 1.6

Ideally, you’d want this ratio to land at 1. 1.6 suggests that more working capital is tied up in inventory than you’d like over the long term. When the ratio is consistently above 2, you need to address your inventory turnover strategy. 

9. Working capital turnover

This metric shows how effectively you deploy working capital to generate sales and revenue. In other words, your money out leads directly to more money in. 

A higher working capital turnover ratio is generally better - this shows that investments are paying off. A low ratio might suggest that you’re holding too much in inventory, or that your sales motions are inefficient. 

Working capital turnover = Net annual sales / Average working capital

Example:

Again, let’s use £10 million in annual sales, and £2,500,000 as your average working capital. 10,000,000 / 2,500,000 gives a working capital turnover ratio of 4:1. So for every dollar of working capital spent, you receive four in return. 

This shows a highly efficient use of working capital. 

Your turn to take working capital seriously

Most small businesses won’t have a close eye on every one of the metrics above. That’s probably overkill. The first four on the list are no-brainers, so it makes sense to measure them routinely. 

Cash conversion cycle and inventory turnover (DIO) are also seen as two of the most valuable growth drivers. The more you can optimise these and avoid tying up working capital, the better. 

Choose the metrics that make most sense for your business, and create processes to track and measure them regularly. Even better, choose dashboard tools that give you an instant look, so you don’t have to live inside spreadsheets 24/7.