Working Capital vs. Cash Flow: The Differences and How to Better Manage Them

Whether you’re a small business or a Fortune 500, good accounting must always be a priority. It’s clear that understanding the financial health of your company will help you make more informed decisions, and that includes differentiating between working capital and cash flow. 

Working capital does tend to affect cash flow, and so the interplay between the two can be confusing sometimes. Both of these are paramount to the running of a business, and while they might seem to have some overlap, they look at two distinct metrics. Once you grasp the basic function of each, they’re relatively easy to take advantage of.

What is cash flow?

In essence, cash flow is exactly what it says on the tin: the money that is flowing through your company. Usually, this is represented over a specific time period which depends wholly on the type of information you’re trying to derive. For most companies, it tends to be in thirty-day increments, as it gives the best balance between the big picture and small picture. There are a variety of good cash flow rules to follow for any business, such as keeping an eye on specific metrics that have large impacts on cash flow. 

You can think about cash flow in the sense of personal finances as well as business. Say you’re moving across the country, which can cost anywhere from $1500 to $6000 on average. This is an expense element, or negative cash flow in the event your expenses are less than what you’re bringing in. On the other hand, if you receive a payment of $2000, that’s considered income or revenue, you’ll generate positive cash flow that can be reinvested in other areas. 

It’s important to note that cash flow doesn’t give you your net profit. Instead, what you’re actually getting is the liquidity of your business, a calculation that is based on a variety of factors. A strong accounting strategy includes things such as preparing a cash flow forecast—which is made easier by using an accounting tool that comes with crucial features like financial statements and automated bank reconciliation. 

What is working capital?

Working capital is the overall operating money that your company has available after debts are removed. It’s what you get when you remove your current liabilities from your current assets. This can factor in a variety of things such as inventory, equipment, investment value, cash on hand, accounts payable, deferred revenue, and debt. 

An important part of any finance management is having access to a lot of positive working capital, as it helps insulate a business against unexpected events. For example, consider the recent chip shortage’s effects on carmakers. As more people went out and bought cars and chips became harder to procure, manufacturers had to account for supply chain issues and resulting sales losses.

With that being said, there is one metric that gives you a pretty good indicator of your working capital, and that’s the current ratio. This is a calculator of all the short and long-term assets set against all the company’s liabilities, and it, therefore, requires a thorough accounting of both sets of data. To that end, you must know how to read a balance sheet so you can calculate the ratio properly and make informed decisions. 

How does cash flow and working capital differ?

When it comes down to it, the main difference between cash flow and working capital is the financial story they tell about your business. Whereas cash flow describes the money moving in and out of your company within a given timeframe, working capital instead compares your business’s assets and liabilities.

Basically, cash flow refers to the bird’s eye view of your business’s present financial situation. It’s different from net profit in that it also includes the money your company is selling on credit as well as the money it’s borrowing. Cash flow can’t tell you much about your company’s net profits since it doesn’t consider any liabilities, but it does provide a snapshot of the amount of cash you’re generating within a given timeframe.

Working capital, on the other hand, considers both your liabilities as well as your assets that you convert to cash or other subsequent liabilities due in fewer than 12 months. If you don’t consider both cash flow and working capital, you’ll be hard-pressed to determine your likelihood of surviving a financial emergency. 

For example: let’s say you have a working capital that’s greater than your liabilities. That’s great news — you can more than likely pay off the debts you owe within a 12-month timeframe. But if you only pay attention to your cash flow, you’ll have no way of confidently saying what your financial position is as it relates to your liabilities and debt owed.

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Metrics and management

There are a variety of ways to manage your working capital and cash flow. For starters, proper inventory management and procurement are essential. This means maintaining stock levels so you aren’t either having too little stock, and therefore losing sales, or having too much stock and paying for more warehousing and storage. Period inventory checks will help you figure out where you stand vis-a-vis your cash flow and working capital.

In a similar vein, it’s important to keep up with payments to your vendors, because you really don’t want to have a huge expense when you least expect it. This is why companies need to have insurance that comes with certain protections such as liability protections for financial crises. In fact, managing debtors is an integral part of management and leads to better overall financial health.

Proper invoicing and amounts receivable processing is another important aspect of making sure things are running smoothly. The faster that you invoice and receive payment, the faster you can add it to your financial metrics, and the better you can gauge how your business is doing. It will also help you understand how to best leverage your liquidity towards investment.

Investments are certainly an important thing to consider, especially when trying to account for long-term costs vs. income. That means that you spend money on long-term investments like new tech that will help the business grow, such as harnessing AI chatbot automation to make business processes more efficient and decrease the number of people you have to hire. 

Keep track of your financial health

Having a thorough grasp of cash flow and working capital—and in general, being able to look at your balance sheet and understand what is going on— is very important. In these uncertain times, the margin of error is minuscule, and a company that isn’t on top of its game in terms of financial health can easily find itself in the red.