Net Working Capital is the simplest way to measure a business’s current liquidity. Learn more about what is net working capital and how it’s calculated below.
Working capital (WC) is sometimes shortened to Net Working Capital (NWC), but they both refer to the same thing. On a company’s balance sheet, current assets and current liabilities are shown as differences.
- The assets of the company include cash, accounts receivable, and inventory.
- A current liability is an outstanding debt, such as accounts payable and accrued expenses.
Calculate the amount of leftover capital by subtracting the liabilities from the assets of the business. With it, you can quickly and easily check a company’s operational efficiency, financial health, and current liquidity.
- A ratio of current assets to liabilities of 1 or higher indicates positive net working capital.
- A ratio of less than 1 indicates negative net working capital.
What does this mean for businesses? Positive working capital gives a company the ability to invest money and grow the business. When the working capital is negative, it is an indication that the business is in debt.
How to calculate working capital
- By determining your working capital ratio, a measure of your company’s short-term financial health, you can determine where you stand today.
- Working capital formula:
- Current assets / Current liabilities = Working capital ratio
- Your working capital ratio is 2:1 if you have $1 million in current assets and $500,000 in current liabilities. Generally, that would be regarded as a healthy ratio, but in some industries or types of businesses, a ratio as low as 1.2:1 may be sufficient.
Net Working Capital tells you how much money you have available to meet your current expenses.
- Net Working Capital formula:
- Current assets – Current liabilities = Net working capital
Consider only short-term assets such as cash in your business account, accounts receivables – the money your customers owe you – and inventory you expect to convert into cash within 12 months when calculating these calculations.
The term “short-term liabilities” refers to a company’s accounts payable – money it owes vendors and other creditors – as well as other debts and accrued expenses such as salary, taxes, and other costs.
How to Interpret Net Working Capital
When the Net Working Capital figure is substantially positive, it means that the short-term funds available from current assets are more than sufficient to cover current liabilities as they become due. When the figure is substantially negative, the business may not have enough funds to pay its current liabilities and may face bankruptcy. Tracking Net Working Capital on a trend line is more informative, as this can demonstrate gradual improvements or declines in the net amount of working capital over a longer period of time.
A company’s net working capital can also be used to estimate its growth potential. It may have enough cash on hand to rapidly expand the company if it has substantial cash reserves. It is unlikely, however, that a business will be able to accelerate its growth rate if it has a tight working capital situation. A more specific indicator of growth is when accounts receivable payment terms are shorter than accounts payable terms, which means that a company can collect cash from customers before paying its suppliers.
Problems with Net Working Capital
Because of the following reasons, Net Working Capital is extremely misleading:
- Line of credit: The business may have a large line of credit available to cover any short-term funding shortfalls mentioned by the Net Working Capital measurement, so there is no real risk of bankruptcy. It is instead used whenever it needs to cover an obligation. Plotting Net Working Capital against the remaining available balance on the line of credit provides a more nuanced view. Liquidity problems are more likely to occur if the line is almost consumed.
- Anomalies: The measurement may include an anomaly, which does not indicate the overall trend of net working capital if it is only measured for one date. In some cases, a large one-time account payable may not yet have been paid, resulting in a smaller Net Working Capital figure.
- Liquidity: Short-term liabilities may not be able to be paid down using current assets because they are not necessarily very liquid. If inventory can be converted to cash at all, it may do so only at a steep discount. In addition, accounts receivable may not be collectible in the short term, especially if credit terms are excessively long. There is a particular problem when large customers have considerable negotiating power over the business and so can deliberately delay their payments.
How to improve net working capital
It may be necessary to make some operational changes to improve Net Working Capital if it is lower than you would like. You may need to make the following changes:
- Follow up with clients as soon as their invoices are due.
- Shorten the billing cycle by changing payment terms.
- Increase payment terms for vendors.
- Receive a refund when inventory is returned unused.
- Find more efficient ways to cycle through inventory.
Increasing your business’s Net Working Capital and its liquidity can be achieved by collecting payments more quickly.
Why should a business calculate the change in net working capital?
The Net Working Capital metric provides a quick view of a business’s ability to meet short-term obligations. An analysis of changes over time can also provide insight into financial health over the long term. Businesses are able to track positive or negative trends by following changes to this figure. As long as your company’s NWC falls within the industry average, this is considered acceptable. A decrease below the average may indicate that the business may default in the future.
New projects or investments may cause a dip in working capital, but a decrease in NWC may also indicate a drop in sales or an increase in overhead. As a result, calculating the change in Net Working Capital is a good way to start investigating efficiency in more detail.