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Net working capital offers a simple way to measure a business’s current liquidity. Find out the answers to what is net working capital and how is it calculated below.
Net working capital explained
Net working capital (NWC) is sometimes shortened to working capital, but both mean the same thing. This term refers to the difference between a company’s current assets and its current liabilities, as listed on the balance sheet.
Current assets include items such as cash, accounts receivable, and inventory items.
Current liabilities refer to outstanding debts like accounts payable and accrued expenses.
By subtracting the business’s liabilities from its assets, you find out the amount of capital that’s left over to work with. It offers a quick, simple way to check a company’s operational efficiency, financial health, and current liquidity.
If the ratio of current assets to liabilities is 1 or higher, the net working capital is positive.
When this ratio is less than 1, it’s negative.
What does this mean for a business? If a company has positive working capital, then it has money to invest and grow the business. However, when the working capital is negative, this is an indication that it is in debt.
Net working capital formula
The standard net working capital formula is:
There are different approaches to calculating net working capital. Some analysts will exclude cash and outstanding debt from the equation, or only choose to include inventory, accounts receivable, and accounts payable into the equation. In this case, the formula would look like:
The reasoning for changing the formulas like this is to examine different areas of the company’s financial health, dependent on what the analyst is most concerned with. However, the first formula is the one that’s most generally used when calculating NWC.
How to calculate net working capital
To calculate net working capital, you can use the main formula listed above to compare the company’s current assets to its current liabilities.
Calculate current assets. These will be listed on the balance sheet, and should include things like inventory, accounts receivable, and cash. Current assets will include anything that can be liquidated within a year’s time.
Calculate current liabilities. Like assets, these will also be listed on the balance sheet. Current liabilities include any payments due within 12 months, like debt repayments and taxes owed. Liabilities also include accounts payable and employee wages within this year’s timeframe.
Use the net working capital formula to subtract current liabilities from current assets.
For example, if Company ABC has current assets of $120,000 and current liabilities of $90,000, then the net working capital would be $30,000.
Why should a business calculate change in net working capital?
Net working capital gives you a quick sense of a business’s ability to cover all short-term obligations. Tracking changes over time can also give a longer-term picture of financial health. Following changes to this figure offers businesses a way to track positive or negative trends. If your company’s NWC falls in line with the industry average, this is considered acceptable. Should it fall below the average, this may indicate that the business is at risk of default in the future.
While new projects or investments can cause a dip in working capital, negative changes to the NWC could also indicate decreasing sales volumes or inflated overhead costs. As a result, you should calculate change in net working capital as the start of a deeper investigation into efficiency.
How to improve net working capital
If your net working capital is lower than you’d like, there are some operational changes to make to improve this figure. Consider taking actions like the following:
Follow up with clients as soon as invoices are due.
Change payment terms to shorten the billing cycle.
Lengthen payment periods for vendors.
Return unused inventory in a timely manner to receive a refund.
Look at more efficient ways to cycle through inventory.
By collecting payments in a timelier manner, you can increase your business’s net working capital along with liquidity.
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