BUSINESS FUNDING

What a Lender Means by Working Capital

By Baruch Mackliff, the Capital Commander · PRBE Capital

Topic: Business funding and what it costs you

Working capital is one of those terms that gets used in two incompatible ways inside the same meeting. An owner uses it to mean cash available to run the business. A lender uses it to mean a specific figure computed from your balance sheet, adjusted by rules you have never seen, and then read as a test rather than a total.

Both meanings are legitimate. The problem is that nobody says which one they are using, so the owner leaves believing the conversation went well and the analyst writes down a number the owner would not recognise.

This is the calculation, where each input comes from on your own statements, what a lender strikes out before it does the arithmetic, and how to work out the amount your business actually has to carry.

The base calculation

Working capital is current assets minus current liabilities. Both sides come from the top half of your balance sheet, and "current" means expected to convert to cash, or come due, within twelve months.

On the asset side you will typically find cash and cash equivalents, accounts receivable, inventory, prepaid expenses and other short-term items such as the current portion of a note owed to you.

On the liability side: accounts payable, accrued expenses including payroll and payroll taxes, taxes payable, the outstanding balance on a revolving line of credit, deferred revenue or customer deposits, and the current portion of long-term debt.

Subtract the second total from the first. That difference is working capital in dollars. The same two totals divided rather than subtracted give you the current ratio, and the same calculation with inventory and prepaid expenses removed from the numerator gives the quick ratio. All three are computed from identical inputs, which is why an error in classification moves every one of them at once.

The line most owners get wrong

The current portion of long-term debt is the single most commonly misplaced figure on a small business balance sheet, and it always moves the number in the wrong direction when it is fixed.

It means the principal payable in the next twelve months on every loan you carry, pulled out of the long-term section and shown as a current liability. If your books leave an entire loan sitting in long-term liabilities, your current liabilities are understated, your working capital looks larger than it is, and your current ratio looks better than it is.

A lender will recompute it from your debt schedule regardless of how your statements present it. Which means the version in the lender's file is the corrected one, and the gap between that and the version you brought to the meeting is a conversation about the quality of your records, not just about the ratio.

The related error is the revolving line balance. A demand or annually renewing line is a current liability because it can come due within the year. Owners frequently treat a line as long-term financing because it has been outstanding for years. That is exactly the pattern a lender reads as a structural problem rather than a seasonal one.

What a lender strikes out before doing the arithmetic

An analyst does not accept your current assets at face value. The adjustments below are standard, and every one of them reduces the number.

• Aged receivables. Invoices past a stated age, commonly measured from the invoice date, are removed. The reasoning is straightforward: a receivable nobody has paid in several months is a collection problem, not a liquid asset. This is why the accounts receivable ageing report matters more than the single balance sheet total.
• Related-party balances. Amounts owed to you by an affiliated company, another entity you control, or an owner are usually struck out entirely. They are not arm's length and they will not be collected in a stress scenario.
• Customer concentration. Where a very large share of receivables sits with a single customer, some or all of the balance above a threshold is treated as ineligible, because the risk is not diversified.
• Prepaid expenses and other soft assets. Prepaid insurance and deposits are current assets under accounting rules but they cannot be converted to cash to pay a supplier, so they are commonly excluded from a liquidity test.
• Inventory. Discounted, sometimes heavily, depending on what it is. Finished goods with an active resale market are treated differently from work in progress, custom or obsolete stock. A lender advancing against inventory will want a listing and, in larger facilities, a physical examination.
• Subordinated owner loans. This one can move in your favour. Money you have lent the business is a liability, but if you sign a standby or subordination agreement committing not to take repayment while the bank loan is outstanding, many lenders will remove it from current liabilities and treat it as equity for the purposes of the test. That document has to exist in writing; a verbal assurance does nothing.

The adjusted figure is what appears in the lender's write-up. If you want to know what a lender will see, run the strike-outs yourself before the meeting.

How much working capital the business actually needs

The subtraction tells you what you have. It says nothing about what you need, and the second question is the one that decides whether a business runs out of cash while profitable.

The amount you must carry is set by your cash conversion cycle: the number of days between paying for something and being paid for it. It is built from three figures, each computed from statements you already have.

Days sales outstanding measures how long customers take to pay. Take your accounts receivable balance, divide it by revenue for the period, and multiply by the number of days in that period.

Days inventory outstanding measures how long stock sits before it sells. Take inventory, divide by cost of goods sold for the period, and multiply by the days in the period.

Days payable outstanding measures how long you take to pay suppliers. Take accounts payable, divide by cost of goods sold, and multiply by the days in the period.

Add the first two and subtract the third. The result is the number of days your own money is tied up in the operating cycle. Multiply that by your average daily cost of sales and you have a working estimate of the cash the business has to hold at rest simply to keep operating at its current size.

Two things follow that are worth sitting with.

Growth consumes working capital. If the cycle is long, every additional dollar of sales requires cash committed up front and returned much later. This is how a business with rising revenue and real profit runs out of money, and it is the single most common reason a healthy company needs a facility.

Shortening the cycle is often cheaper than financing it. Invoicing on completion rather than monthly, tightening collection on the slowest accounts, taking deposits on custom work and negotiating supplier terms all reduce the amount of capital the business must carry. A lender who sees that work already underway reads it as competence, which affects the conversation you are about to have.

When negative working capital is fine and when it is not

A negative figure means current liabilities exceed current assets, and it is not automatically a warning.

Some business models collect from customers at the point of sale and pay suppliers on terms. Money arrives before it goes out, the operating cycle is funded by suppliers rather than by the owner, and the balance sheet shows negative working capital permanently and healthily. Restaurants, some retail and subscription businesses billed in advance all look like this.

What makes a negative figure dangerous is the composition rather than the sign. Negative because customers prepay is structural. Negative because payables have aged, payroll taxes are accrued and unpaid, and a revolving line has been fully drawn for eighteen months is a business consuming its own float. Any competent analyst separates those two in the first ten minutes, from the payables ageing and the line balance history.

Why the date you hand over matters

Nearly every business has a most flattering day of the year, and for most of them it is the fiscal year end, because that is when inventory is at its lowest and collections have been pushed hardest.

A lender looking at a seasonal business will not be satisfied with that date. Expect a request for interim statements at the point in the season where the business is most stretched, and for monthly or quarterly figures across a full cycle. The question being answered is not what your balance sheet looks like at its best but whether the facility is sized for the trough.

Prepare for that rather than resisting it. A business that can explain its own seasonal low point, with the statements to support it, is asking for a correctly sized facility. A business that only produces year-end figures is asking the lender to guess, and lenders guess conservatively.

What to put in front of a lender

Bring the interim balance sheet and income statement, dated recently, along with the year-end statements. Bring a receivables ageing and a payables ageing from the same date as the interim balance sheet, so the two reconcile. Bring a debt schedule listing every obligation with its lender, original amount, current balance, payment, rate, maturity and collateral, because that is where the current portion of long-term debt is verified. If inventory is material, bring a listing rather than a single number. If you have lent money to the business, bring the note and any subordination agreement.

Then do the subtraction yourself, twice: once as your statements present it and once after the standard strike-outs. Walking in with both versions, and knowing why they differ, changes the tenor of the meeting more than any single ratio does.

PRBE Capital works with owners at exactly that point: recomputing the figure the way a credit file will, measuring the operating cycle from your own statements, and sizing the request against what the business genuinely has to carry rather than against a round number. The first conversation costs nothing and promises no approval.

This is an explanation of how the calculation is built and read, not legal, accounting or financial advice. Adjustment rules, eligibility thresholds and ratio requirements differ by lender and by facility and change over time, so confirm the ones that apply to your file in writing with your lender and your accountant.

Common questions

What is working capital in simple terms?

It is current assets minus current liabilities: what the business owns that will turn into cash within a year, less what it owes within the same year. The figure tells you whether the business can cover its near-term obligations out of its near-term resources. It is a measure of liquidity, not of profit.

How do you calculate working capital from a balance sheet?

Total the current asset section, which typically includes cash, accounts receivable, inventory and prepaid expenses, then total the current liability section, which includes accounts payable, accrued expenses, taxes payable, any revolving line balance and the principal due on loans in the next twelve months. Subtract the second from the first. Divide instead of subtracting and you have the current ratio.

Why is a lender's working capital number different from mine?

Because the analyst adjusts the inputs before doing the arithmetic. Aged receivables, balances owed by affiliated companies, prepaid expenses and a portion of inventory are commonly removed from current assets, and the principal due within a year on every loan is added to current liabilities whether or not your statements show it that way. Run those same adjustments yourself and the two figures converge.

What is the current portion of long-term debt?

It is the principal payable over the next twelve months on your long-term loans, reported as a current liability rather than left in the long-term section. It is the most commonly misplaced line on a small business balance sheet, and leaving it out overstates working capital. A lender recomputes it from your debt schedule regardless of how your books present it.

Can working capital be negative and still be healthy?

Yes, for businesses that collect at the point of sale and pay suppliers on terms, where the operating cycle is effectively funded by suppliers. What matters is the composition rather than the sign. Negative because customers pay in advance is structural; negative because payables have aged and a line of credit has been fully drawn for a year is a warning.

How much working capital does my business need?

Measure your cash conversion cycle: days sales outstanding plus days inventory outstanding minus days payable outstanding, each computed from your own statements. Multiply the result by your average daily cost of sales for a working estimate of the cash the business must hold at rest. The longer the cycle, the more capital every additional dollar of growth consumes.

What is the difference between working capital and cash flow?

Working capital is a position measured on one date, taken from the balance sheet. Cash flow is movement measured over a period, taken from the cash flow statement or reconstructed from the income statement. A business can show positive working capital and still fail to cover a payment due this week, which is why lenders read both.