Net working capital (NWC) is the difference between a company’s current assets and current liabilities. A positive net working capital indicates a company has sufficient funds to meet its current financial obligations and invest in other activities. For example, if current assets are $85,000 and current liabilities are $40,000, the NWC is $45,000.
Net Working Capital Formula
It is relatively simple to calculate the net working capital of a company. We will show you the formula below.
The net working capital (NWC) formula is:
Net Working Capital = (Cash and Cash Equivalents) + (Marketable Investments) + (Trade Accounts Receivable) + (Inventory) – (Trade Accounts Payable)
– OR –
Net Working Capital = (Current Assets) – (Current Liabilities)
Net Working Capital Example
Now that you understand the equation, let’s now take a look at each component of net working capital below. This will help you calculate your current assets, current liabilities, as well as your overall net working capital.
Current Assets
Current assets are short-term assets found on your balance sheet that can be converted to cash within 1 year or less. Current assets typically include cash and cash equivalents such as treasury bills, short-term government bonds, commercial paper, and money market funds. Marketable securities, accounts receivables, and inventories are also considered current assets.
For example, your company has cash and cash equivalents of $50,000, accounts receivable of $5,000, and total inventories worth $10,000. To calculate the total current assets, you simply sum these values together:
$50,000 + $5,000 + $10,000 = $65,000
Current Liabilities
Current liabilities are short-term financial obligations due in 1 year or less. Current liabilities usually include short-term loans, lines of credit, accounts payable, accrued liabilities, and other debts such as credit cards, trade debts, and vendor notes. Current portions of long-term debt like commercial real estate loans and small business loans are also considered current liabilities.
For example, your company has a $20,000 short-term loan, accounts payable of $7,000, and accrued liabilities of $4,000. To calculate the total current liabilities, you need to add all these values individual current liability numbers:
$20,000 + $7,000 + $4,000 = $31,000
For more information, you can read our in-depth article on current liabilities.
Now that you have the values for both current assets and current liabilities, the next step is to subtract the current liabilities from the current assets to get the value of your net working capital. Using the above figures, the calculation is as follows:
$65,000 – $31,000 = $34,000 NWC
Why is Net Working Capital Important?
NWC is important because it represents your short-term business assets available to pay your short-term obligations and also invest in income-producing activities. It can serve as a good indicator regarding how efficiently a business is operating and how financially solvent it is in the short-term.
For example, a positive net working capital means that a company has the short-term liquidity to pay its current obligations as well as invest in its future growth. A net zero working capital means a company can only meet its current financial obligations and a negative net working capital means that a company will typically need to borrow or raise money to remain solvent.
Changes to Net Working Capital
Changes to net working capital is a measure of operating cash flow (OCF) and is typically recorded on your statement of cash flows. The change in net working capital can show you if your short-term business assets are increasing or decreasing in relation to your short-term liabilities from one period to the next.
However, an increasing or decreasing net working capital isn’t necessarily bad or good. Sometimes strategic business decisions call for an increase in short-term liabilities in the near-term. Other times, an increasing net working capital can show that more of your cash is tied up in assets that might not be as liquid. It’s important to track the changes in net working capital so you can monitor your operating cash flow.
To measure the change, you can use the following formula:
(Current Net Working Capital) – (Previous Net Working Capital)
Net Working Capital Ratio
The net working capital (NWC) ratio measures the percentage of a company’s current assets to its short-term liabilities. Similar to net working capital, the NWC ratio can be used to determine whether or not you have enough current assets to cover your current liabilities.
The net working capital ratio can be calculated as follows:
(Current Assets) / (Current Liabilities)
The optimal ratio is to have between 1.2 – 2 times the amount of current assets to current liabilities. Anything higher could indicate that a company isn’t making good use of its current assets. Liquidity measures such as the quick ratio and the working capital ratio can help a company with its short-term asset management.
Pros and Cons of Net Working Capital
Net working capital is a key indicator of your business’s short-term liquidity. It demonstrates whether or not your company has enough working capital to both meet its current financial obligations as well as invest in its growth.
Pros of Net Working Capital:
- Positive net working capital means you can meet your current financial obligations.
- You can invest in other operational needs if you have a positive net working capital.
Cons of Positive Net Working Capital:
- Too much can mean your business isn’t using its short-term assets efficiently.
- Net working capital does not always provide an accurate liquidity measure because some current assets can’t be easily converted to cash.
How to Increase Your Net Working Capital
There are many ways to improve your net working capital. These include the selling of long-term assets for cash, increasing inventory turnover, and refinancing short-term debts with long-term debts. Doing these things will help improve your business’s short-term liquidity.
Below are 3 ways to increase your net working capital (NWC):
1. Sell 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 office equipment, consider selling them for cash. This will increase your NWC since cash is a current asset while equipment is a long-term asset and isn’t included in the NWC formula.
2. Increase Inventory Turnover
Take time to review your inventory and find ways to increase your inventory turnover so you don’t become overstocked. While inventory is a current asset, it’s not as liquid as cash and you can typically sell your inventory for a premium. For example, if your inventory is worth $1,000 but you are able to sell it for $1,500 in cash, your current assets will increase by $500.
3. Refinance Short-Term Debt with Long-Term Debt
Short-term debts are current liabilities due in 1 year or less. When you refinance short-term debt with long-term debt, it 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 your current liabilities.
Bottom Line
Net working capital measures a company’s ability to meet its current financial obligations. When a company has a positive net working capital, it means that it has enough short-term assets to finance to pay its short-term debts and even invest in its growth. Companies can increase their net working capital by increasing their current assets and decreasing their short-term liabilities.
