Net Working Capital: What It Is and How to Calculate It
What is net working capital?
Net working capital (NWC) is current assets minus current liabilities.
It’s a calculation that measures a business’s short-term liquidity and operational efficiency. It’s also important for predicting cash flow and debt requirements.
Net working capital is also known simply as “working capital.”
NWC is a way of measuring a company’s short-term financial health. In other words, a company’s ability to meet short-term financial obligations. Its ability to keep running and growing business operations.
You take all your total current assets. You subtract your current liabilities. You arrive at your amount of net working capital.
Positive working capital is generally good. Negative working capital is generally not so good. Of course, there are exceptions.
In some cases positive working capital can be a bad thing. Excessive NWC may for a long period of time can indicate a business is failing to use assets effectively.
In some cases negative working capital can be a good thing. Sometimes a business is growing fast and generating cash. They don’t have to pay their big bills till later. They’re effectively using borrowed money to grow.
It’s important to know how to calculate NWC. Here’s how to do it.
Net working capital formula
To do a net working capital calculation, you can use the following simple formula.
Net Working Capital = Current Assets - Current Liabilities
Yes, there isn’t much more to the working capital calculator. But if you want to know what to include in “Current Assets” and “Current Liabilities,” see the following section.
How to calculate net working capital
When calculating current assets, make sure to include the following:
Cash and cash equivalents.
Accounts receivable (i.e. bills sent to customers but not yet paid).
Prepaid expenses (expenses paid in advance that haven’t expired).
Marketable securities or marketable investments. This includes any stocks, bonds, and other holdings. All assets that can be liquidated and turned into cash within a year or less.
Any other liquid assets.
When calculating current liabilities, make sure to include the following:
Accounts payable (invoices payable to suppliers).
Taxes: including sales taxes, payroll taxes, and income taxes.
Interest payable (interest still owed to lenders).
Accrued expenses. This includes all expenses not yet paid, but already incurred.
Short-term loans that will need to be repaid within the next year.
Net Working Capital Example
Here’s a quick example to illustrate NWC in action.
A small business wants to know their net working capital. So they do their due diligence. They add up their cash, inventory, accounts receivable, etc.
When all is said and done, they find they have $80,000 in current assets.
Then they calculate their liabilities. Their accounts payable, taxes, and so forth.
They find they have $47,000 in current liabilities.
They take this figure for current liabilities and subtract it from current assets. The math works out like this.
$80,000 - $47,000 = $33,000.
The company has $33,000 in net working capital. This $33,000 can be used to meet short-term obligations. It can cover operational costs and other business costs.
The small business appears to be in good shape, with room to flex and absorb expenditures.
Why is net working capital important?
Some think that NWC is only important to those in corporate finance. But it’s actually key to the economic survival of any business. Small business owners are among those who really should know NWC.
Net working capital is important for several reasons.
For one, it can indicate a company’s potential to grow and invest and avoid bad trade debt.
Positive net working capital can indicate free cash flow. A company’s current assets are sufficient to meet business needs.
Negative net working capital may signal danger. When a company’s assets are less than its total current liabilities, it may have trouble paying creditors. In the worst case, it can indicate looming bankruptcy.
With that said, it should be noted NWC has limitations.
If a business has a line of credit, it might conceal liquidity problems. They may be able to pay obligations despite weak cash flow. Thus NWC should always be compared with the remaining balance left on any lines of credit.
Current assets might not necessarily be liquid. For example, payment from a large customer may be delayed significantly. Inventory might also not be convertible to cash in the short-term. If it is, it might have to be significantly discounted.
The period of time measured may be flawed. Say a business has some huge one-time expense. This may lead to a skewed NWC.
And of course, it’s important to note the qualitative differences between short-term assets and fixed, long-term assets.
Net working capital ratio
Net working capital ratio is found by dividing current assets by current liabilities.
You can use the following formula for calculating NWC ratio.
Net Working Capital Ratio = Current assets ÷ Current Liabilities
Here’s a couple examples.
A business has current assets totaling $150,000 and current liabilities totaling $100,000. That means their NWC ratio is 1.5. It’s positive.
A business has current assets totaling $100,000 and current liabilities totaling $135,000. That means their NWC ratio is 0.74. It’s negative.
If your working capital ratio is below 1, it may indicate a company is in a risky position.
If your working capital ratio reaches 2, it may indicate a company is sitting on assets and not growing efficiently.
How to improve net working capital
There are many ways to improve net working capital.
A company can simply improve its profits. Selling more products and making more money will boost NWC.
Shortening the payment cycle can increase cash flow.
Many small businesses struggle with getting customers to pay. You can extend rewards and special offers to customers who pay on time. Streamlining invoicing and accounts receivable helps too.
Avoid ordering too much inventory. And avoid buying new technology or equipment when you can lease it for a better return on investment.
Replacing your short-term debts with long-term debts is also very important.
It’s vital to work with suppliers and financiers to win better payment terms. Payment extensions give a company much-needed breathing space. And it can increase the company’s cash balance.
On that note, one other way to boost NWC is by selling long-term assets for cash. Of course, depending on long-term business goals, this may not be advisable.
How to increase your net working capital: step one
To get started on increasing your NWC, you can ask yourself some questions.
Do you think you’re using your assets to their full potential? Is there a way to generate more cash flow?
And is there a way to minimize overhead yet maintain profits?
it’s important not to fall into the trap of constantly getting loans and selling equity. This can have serious impacts on your business’s viability down the line.
Before looking outside, you should really try and optimize everything inside. There are certainly “housekeeping” tasks for improving your balance sheet.
Spend responsibly. Manage your wins and re-invest them wisely. Do the most you can with the assets you have.
Because with better working capital management, you’ll find your business better equipped to negotiate. And better equipped to grow.