Working Capital: How Much Money Should Stay in Circulation

Working Capital: How Much Money Should Stay in Circulation

Working capital is the money that's constantly tied up in the day-to-day running of a business: sitting in inventory, waiting to be paid by customers, and covering upcoming bills. It's the part of your money that's never actually free while the business is running.

That's exactly why a profitable business often has a modest bank balance: a large share of what it earns goes straight back into circulation. Let's work out how to calculate your working capital and how much you need to keep in it for operations to run smoothly.

In plain terms. Picture a café. To sell coffee tomorrow, the beans have to be bought today. To fill an order for an office, the ingredients get bought a week before payment arrives. Money is constantly moving: it turns into inventory, then into an order, then back into money. Working capital is the amount that's permanently caught in that loop.

What working capital is

It's the difference between what will soon turn into cash and what will soon need to be paid out.

The logic is simple: if upcoming inflows plus cash on hand exceed upcoming outflows, the business moves through its operating cycle without trouble. If it's less, you end up looking for outside money or delaying payments.

The formula and what goes into it

Working capital = Current assets − Current liabilities

The selection rule is the same for both columns: it includes whatever will turn into cash, or needs to be paid, within a year. Equipment and premises don't belong here — they're used for years and don't take part in the daily cycle.

The calculation, worked in numbers

Let's take a small retail business.

Working capital comes out to $25,500. That's your safety margin: even if every upcoming obligation had to be settled at once, the business would still have this amount of resources left to work with.

Notice the structure. Only $8,500 is free cash — the remaining $36,500 sits in inventory and in customers' unpaid invoices. That's a normal picture for a retail business, and it's exactly why profit rarely lines up with the balance in the account.

The current ratio

The figure by itself doesn't say much until you compare it against liabilities. That's what the current ratio does.

Current ratio = Current assets ÷ Current liabilities

In our example: $45,000 ÷ $19,500 = 2.3.

Our 2.3 sits above the comfortable range. That's a strong cushion, but it's worth checking whether inventory levels are too high: money sitting in stock could be working differently. More on that in the section on excess below.

Cash conversion cycle: the number that matters most

Working capital in dollars answers “how much.” But for decisions, it's more useful to know “for how long” — how many days your money is out of circulation before it comes back. That's the cash conversion cycle, and it has three parts.

How many days money sits in inventory

Inventory ÷ Annual cost of goods sold × 365

In the example: $20,000 ÷ $120,000 × 365 = 61 days. That's how long, on average, goods sit in stock between purchase and sale.

How many days you wait to be paid

Accounts receivable ÷ Annual revenue × 365

In the example: $16,500 ÷ $200,000 × 365 = 30 days. That's how long, on average, passes between a sale and the money arriving.

How many days your supplier gives you

Money owed to suppliers ÷ Annual cost of goods sold × 365

In the example: $10,000 ÷ $120,000 × 365 = 30 days. This is the only part that works in your favor: until you pay the supplier, you're using their money.

Now let's put it all together.

Cycle = 61 + 30 − 30 = 61 days

That means: from the moment you pay for goods to the moment the money for them comes back, 61 days pass. For two months, your money is in motion and unavailable for anything else.

How much money to keep in circulation

Now the cycle gives you a specific amount. The logic: for all 61 days, the business is incurring costs, and the money for that period hasn't come back yet. So you need a reserve that covers those days.

Need = Daily costs × Cash conversion cycle

Let's calculate. The business's annual operating costs are $175,200, which is about $480 a day.

$480 × 61 days ≈ $29,000

That's the answer to the question in the headline: roughly $29,000 needs to stay in circulation at all times for the business to run smoothly. This isn't a rainy-day reserve — it's working capital that's constantly in motion.

Advice. Once you've calculated this figure, you have a benchmark for two decisions: how much you can take out of the business without hurting operations, and how much money you'll need if you're planning to grow. Without this number, both questions get decided by gut feeling.

Four ways to reduce the need

The shorter the cycle, the less money you need to hold. There are exactly four levers, and each one is visible right in the formula.

Every day trimmed from the cycle frees up about $480 — your daily operating cost. Shortening the cycle by two weeks frees up around $6,700 in cash, with no outside financing at all.

When there's too much working capital

A large working capital balance looks safe, but it comes at a cost. Money sitting in excess inventory or in long customer payment terms isn't earning anything — it's just waiting.

Signs that the balance can be trimmed: a current ratio consistently above 2.5, inventory turning over noticeably slower than in past periods, or receivables growing faster than revenue. In any of these cases, some of that money can be freed up and redirected to where it's actually working.

It's like food in the fridge at home: you always need some on hand, but a fridge stocked a month ahead just means money is sitting in a form that's hard to get back out.

Why growth needs more money

This is a consequence worth seeing ahead of time. The need for working capital grows roughly in proportion to volume: twice the sales means roughly twice the inventory and twice the receivables.

In our example, doubling turnover would raise the need from roughly $29,000 to about $58,000. That additional money has to come from somewhere — accumulated profit, supplier terms, or outside financing. And it's needed upfront, before growth starts generating cash of its own.

That's why, before expanding, it's worth calculating not just future profit, but how much additional money you'll need to hold in circulation.

How to calculate this from your own data

Every formula in this article needs five numbers: cash on hand, inventory, receivables, payables, and annual cost of goods sold. All of them come straight from your books, as long as transactions are entered and sorted into categories.

In BizFin, account and till balances show up under “My Accounts,” and debts in both directions show up under “Debts”: the “Owed to me” figure gives you receivables, “I owe” gives you payables. The “Balance Sheet” report pulls it all together: current assets, current liabilities, and the difference between them — your working capital as of a specific date.

Annual cost of goods sold comes from the “Profit and Loss” report, provided direct costs are broken out as their own category in “Directories.” With these numbers in hand, the whole cycle calculation takes a few minutes.

It's worth doing once a quarter and watching the trend: a cycle that's stretching out means you need more money in circulation than before — and it's better to catch that early.

What's worth remembering

• Working capital is money tied up in daily operations. It's never free while the business is running.

• The formula is simple: current assets minus current liabilities. Equipment and premises aren't included.

• The key figure is the cash conversion cycle, in days. It shows how long your money is out of circulation.

• The need is calculated as daily costs × cycle. That's the amount you need to keep in circulation.

• Growth increases the need proportionally. The money for that is needed upfront.

Frequently asked questions

What is working capital, in plain terms?

It's the amount permanently tied up in running the business: sitting in inventory, waiting to be paid by customers, and covering upcoming bills. It's calculated as current assets minus current liabilities.

How is working capital different from the money in the account?

The money in the account is only one part of it. In the example in this article, out of $45,000 in current assets, only $8,500 was free cash, with the rest sitting in inventory and unpaid customer invoices. That's why a profitable business can have a modest balance.

How much working capital should a business have?

The benchmark comes from the calculation: daily operating costs multiplied by the cash conversion cycle in days. It's also worth checking the current ratio — for most small businesses, a comfortable range is 1.5 to 2.0.

What is the cash conversion cycle?

It's the number of days between paying for goods or materials and getting the money back from the customer. It's calculated as days of inventory plus days waiting to be paid, minus the days of delay your supplier gives you.

How do you reduce the need for working capital?

Four levers: sell inventory faster, shorten customer payment terms, negotiate longer terms with suppliers, and take prepayments. Every day trimmed from the cycle frees up an amount equal to your daily operating costs.

Can a business have too much working capital?

Yes. A current ratio consistently above 2.5 usually means some of the money is sitting in excess inventory or in long customer payment terms. That money can be freed up and redirected to where it's actually working.