What is Net Working Capital and How is It Calculated
Net working capital represents the cash and other current assets, after covering liabilities, that provide a company with the liquidity to invest in activities associated with operating and growing a business.
Many people use net working capital as a financial metric to measure the cash and operating liquidity position of a business. It consists of the sum of all current assets and current liabilities. Net working capital measures the short-term liquidity of a business, and can also indicate the ability of company management to utilize assets in an efficient manner.
The amount of net working capital a company has available can also be used to determine if the business can grow quickly. With substantial cash in its reserves, it may have enough to scale the business rather fast. Conversely, if the business has very little in cash reserves then it's highly unlikely that the company has the resources to handle fast-paced growth.
Management, vendors, and general creditors watch a company’s net working capital because it provides a snapshot at any given time of the firm's short-term liquidity and ability to pay off its current liabilities with current assets.
Calculating Net Working Capital
Net Working Capital = Current Assets - Current Liabilities
For example, if a business has current assets of $200 and current liabilities of $100, then:
- Net Working Capital = Current Assets - Current Liabilities
- =$200 - $100
- =Net Working Capital=$100
This firm can pay its short-term liabilities, such as debt obligations, and still have $100 left over as a cash or operating liquidity cushion. It has twice the current assets ($200) as current liabilities ($100).
The Current Ratio
The net working capital metric is directly related to the current, or working capital ratio. The current ratio is a liquidity and efficiency ratio that measures a firm's ability to pay off its short-term liabilities with its current assets. Looking at the calculation of the current ratio, you’ll see that you use the same balance sheet data to calculate net working capital.
Compare this to the current ratio. If you calculate the current ratio for this example, you would use the current ratio formula:
- Current Ratio = Current Assets / Current Liabilities
- $200/$100 = 2.00X
- Current ratio = 2.00X
The two financial metrics are very closely related. A current ratio of 1 or higher indicates that the company can cover its obligations for the next year. A ratio above 2, however, might indicate that the company could benefit from managing its current assets or short-term financing options more efficiently.
Changing Assets and Liabilities
Changes to either assets or liabilities will cause a change in net working capital unless they are equal.
For example, If a business owner invests an additional $10,000 in her company, its assets increase by $10,000 but current liabilities do not increase. Thus, working capital increases by $10,000.
If that same company were to borrow $10,000, and agree to pay it back in less than one year, the working capital has not increased, because both assets and liabilities increased by $10,000.
Should that same company invest $10,000 in inventory, working capital will not change because cash decreased by $10,000, but assets increased by $10,000.
The same company sells a product for $1,000, which it held in inventory at a cost of $500. Working capital increases by $500 because accounts receivable, or cash, increased by $1,000 and inventory decreased by $500.
The company now uses $1,000 to buy equipment. That will reduce working capital because the asset cash decreased, but the equipment has more than a one-year life, so it falls under long-term assets and doesn’t affect the net working capital calculation.
Cash management and the management of operating liquidity is important for the survival of the business. A firm can make a profit, but if it has a problem keeping enough cash on hand, it won't survive. It’s important for a business owner to use all the financial metrics and measures available to continually manage liquidity and cash availability.
Increasing Net Working Capital
If your business has difficulty meeting its financial obligations and needs more net working capital, a few strategies can help free up cash and increase working capital funds.
- Sell Off Long-Term Assets: If your business has equipment and other long-term assets such as buildings, consider selling off unused equipment or subleasing unused building space. This can provide needed cash to increase your current assets and working capital. Some companies sell their own commercial buildings to generate cash and subsequently lease the facilities back from the new owner at a payment that fits within their expense budget while putting the cash proceeds to work in other areas of the business.
- Increase the speed of inventory turnover: Holding months’ worth of inventory instead of selling it ties up cash, and if you have slow-moving products or an inefficient inventory management process, your business could be caught with very little working capital. Discount slow-moving items, and revamp your company’s restocking procedures to get inventory ordered, received and out to customers or retailers more quickly. Focus on fast-selling inventory and don’t over-order, especially during slow-selling times of the year. Review your list of inventory items and reconsider spending on items that have low demand or infrequent sales.
- Refinance short-term or expensive debt: Short-term debt refers to loans that will be paid in one year or less and fall under the current liabilities category. Refinancing short-term loans with long-term debt can stretch out payment schedules and lower monthly payments, providing more cash for working capital. Long-term loans fall under the balance sheet’s long-term liabilities section and don’t factor into the working capital calculation.