Net Working Capital: What It Is & How To Calculate It
This article is part of a larger series on Business Financing.
Net working capital (NWC) is the difference between a company’s current assets and current liabilities and is one indicator of the solvency of a business. A positive NWC indicates that a company has sufficient funds to meet its current financial obligations and invest in other activities. NWC is figured by deducting liabilities from current assets so, for example, if current assets are $85,000 and current liabilities are $40,000, the business’s NWC is $45,000.
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Net Working Capital Formula
Net working capital = Current assets – Current liabilities
Current Assets
Current assets are items on your balance sheet that can be converted to cash within one year or less. This includes cash and cash equivalents, such as:
- Treasury bills
- Short-term government bonds
- Commercial paper
- Money market funds.
Marketable securities, accounts receivable (A/R), and inventory are also considered current assets. We have a guide on what assets are in accounting if you’d like to learn more.
Current Liabilities
Current liabilities are short-term financial obligations due within one year. Current liabilities usually include:
- Short-term loans
- Lines of credit
- Accounts payable (A/P)
- Accrued liabilities
- Other debts, such as credit cards, trade debts, and vendor notes
The sum of monthly payments of long-term debt, such as commercial real estate (CRE) loans and small business loans, which will be made within the next year are also considered current liabilities.
To help you figure out your current liabilities, we included a calculator in our article on current liabilities.
Let’s say your company has the following current assets:
- Cash and cash equivalents of $50,000
- A/R of $5,000
- Total inventory worth $10,000
- Current Assets = $50,000 + $5,000 + $10,000 = $65,000
Plus, your company has the following current liabilities:
- $20,000 short-term loan
- A/P of $7,000
- Accrued liabilities of $4,000
- Current Liabilities = $20,000 + $7,000 + $4,000 = $31,000
Once you have determined both current assets and current liabilities, subtract the liabilities from the assets to determine NWC.
$65,000 (current assets) – $31,000 (current liabilities) = $34,000 (NWC)
Net Working Capital Calculator
Why Is Net Working Capital Important?
NWC indicates the number of short-term business assets that are available for a business to pay its short-term obligations and also invest in income-producing activities. It also serves as a good indicator of short-term business solvency.
A positive NWC means that a company has the short-term liquidity to pay its current obligations and invest in its future growth. Keep in mind, though, that while a business should have a positive NWC, an NWC that’s too high signifies a business that may not be investing its short-term assets efficiently. On the other hand, a negative NWC means that a company will typically need to borrow or raise money to remain solvent.
Changes in Net Working Capital
Changes in NWC show trends in operating cash flow over a period. The change can show you if your short-term business assets are increasing or decreasing in relation to your short-term liabilities.
An increase or decrease in NWC is useful for monitoring trends in liquidity from year to year or quarter to quarter over a period of time.
It’s worth noting that if you make a major decision, such as taking out a loan or a lease for equipment, your NWC will be impacted in the near term. The trendline over several points in time is more useful in assessing changes in NWC.
To measure the change, you can use the following formula:
Change In Net Working Capital = Current Net Working Capital – Previous Net Working Capital
Net Working Capital Ratio
The NWC ratio, also known as the current ratio, measures the percentage of a company’s current assets to its short-term liabilities. Similar to NWC, the NWC ratio can be used to determine whether you have enough current assets to cover your current liabilities.
The NWC ratio can be calculated as follows:
Current Assets | |
Net Working Capital Ratio = | Current Liabilities |
The optimal NWC ratio runs from 1.2 to 2.0. Anything higher could indicate that a company isn’t making good use of its current assets.
Additional financial calculations, such as the quick ratio and the fixed charge coverage ratio, can help a company with its short-term asset management and are among the loan requirements looked at by lenders as part of their underwriting process.
Limitations of Net Working Capital Calculation
While calculating the NWC is important in determining the financial health of your business, there are some limitations to this calculation.
- It might not accurately reflect cash flow: If your business has large current liabilities, like a line of credit, you might show a negative NWC despite the fact your business is meeting its obligations.
- It is only a snapshot in time of your financial health: This is why calculating a change in NWC is so important. That will give you a longer-term picture of the financial stability of your business.
- It cannot account for accounting errors or external issues: If a company isn’t following sound accounting practices or is dealing with such things as inventory theft or A/R companies going out of business, this number may not be an accurate picture of the company’s current financial state.
Ways To Increase Net Working Capital
Businesses looking to improve their NWC should use these three tips.
1. Sell Some Long-term Assets for Cash.
Long-term assets such as equipment and machinery are not considered current assets. If your company has unused long-term assets like old equipment, consider selling them for cash if those assets are still in good condition. Cash is a current asset and counts toward your NWC.
2. Increase Inventory Turnover.
Look at where you can unload some of your surplus inventory so you don’t become overstocked. While inventory is a current asset, it’s not as liquid as cash and you can often sell your inventory at a premium. For example, if you are sitting on $10,000 worth of excess inventory but you can sell it for $15,000 in cash, your current assets will increase by $5,000.
3. Refinance Into Longer-term Debt.
Short-term debts are current liabilities that are due within one year. If you have any short-term debts with higher interest rates, consider refinancing to a longer term. By doing this, the debt will no longer be included in the calculation of your NWC, aside from the total portion of principal due in one year. This will help increase your NWC by lowering the number of payments that are due.
Bottom Line
NWC measures a company’s ability to meet its current financial obligations. When a company has a positive NWC, it means that it has enough short-term assets to pay for its short-term debt and even invest in its growth. Keep in mind that NWC is only one indicator of the financial health of a company and should be considered along with other ratios listed in this guide.
