What is working capital?

Working capital is the difference between your current assets (cash, accounts receivable, inventory) and current liabilities (accounts payable, credit cards, current portion of loans). For professional service firms, working capital represents the liquid resources available to fund daily operations. Positive working capital means current assets exceed current liabilities; negative working capital means short-term obligations exceed readily available resources. A consulting firm with $300,000 in cash and AR but only $80,000 in AP and short-term debt has $220,000 in working capital to fund operations and growth.

Key characteristics of working capital

• Calculated as: Current Assets - Current Liabilities

• Measures: Short-term financial health and operational flexibility

• Changes with growth: Expanding firms need more working capital to fund the increase in AR increases

• Industry standards: Service firms typically maintain 2-3 months of operating expenses

• Managed through: AR collections, AP timing, credit lines, and owner contributions

Why working capital matters for service firms

Adequate working capital prevents cash crunches during growth. A consulting firm doubling from $2M to $4M revenue needs an additional $150,000-$250,000 in working capital to fund the proportional AR increase, even if highly profitable. Insufficient working capital forces reactive decisions: delaying vendor payments, drawing expensive credit lines, or postponing strategic hires. Monitoring working capital monthly reveals trends: declining working capital despite profitability signals collection problems or overspending; growing working capital indicates improving cash generation and financial strength.

Example: Working capital calculation and management

Current assets:

• Cash: $185,000

• Accounts receivable: $320,000

• Prepaid expenses: $15,000

• Total current assets: $520,000

Current liabilities:

• Accounts payable: $48,000

• Credit cards: $22,000

• Accrued payroll: $85,000

• Current portion of term loan: $24,000

• Line of credit: $125,000

• Total current liabilities: $304,000

• Working capital: $216,000

• Working capital ratio: 1.71 (current assets / current liabilities)

• Healthy range: 1.5-2.5

• Below 1.0: Potential liquidity crisis

• Above 3.0: Inefficient capital use

• Monthly operating expenses: $180,000

• Months of working capital: 1.2 months

• Target: 2-3 months = $360,000-$540,000

Action plan to improve:

• Reduce DSO from 48 to 38 days (+$55,000)

• Negotiate better vendor terms (+$15,000)

• Reduce credit card balances (-$22,000 liability)

• Projected working capital after improvements: $264,000