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 an indicator of the solvency of a business. Positive net working capital indicates that 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 business’s NWC is $45,000.
Net Working Capital Formula
Net working capital = Current assets – Current liabilities
Current assets are those 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, and money market funds. Marketable securities, accounts receivable (A/R), and inventory are also considered current assets.
For example, your company has cash and cash equivalents of $50,000, A/R of $5,000, and total inventory worth $10,000. Your current assets are the sum of these items ($50,000 + $5,000 + $10,000 = $65,000).
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, and other debts, such as credit cards, trade debts, and vendor notes. The sum of monthly payments of long-term debt―like commercial real estate loans and small business loans―that will be made within the next year are also considered current liabilities.
In our example, if your company has a $20,000 short-term loan, A/P of $7,000, and accrued liabilities of $4,000, your current liabilities are $31,000 ($20,000 + $7,000 + $4,000).
Once you have determined both current assets and current liabilities, subtract the liabilities from the assets to determine net working capital.
$65,000 (current assets) – $31,000 (current liabilities) = $34,000 (net working capital)
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.
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. Negative net working capital, however, means that a company will typically need to borrow or raise money to remain solvent. Keep in mind that while a business should have positive net working capital, an NWC that’s too high signifies a business that may not be investing its short-term assets efficiently.
Changes in Net Working Capital
Changes in net working capital show trends in operating cash flow over a period of time. 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.
An increase or decrease in net working capital 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 net working capital will be impacted in the near term. The trendline over several points in time is more useful in assessing changes in net working capital.
To measure the change, you can use the following formula:
(Current Net Working Capital) – (Previous Net Working Capital)
Net Working Capital Ratio
The 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 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 net working capital ratio is between 1.2 and 2.0. 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 current ratio can help a company with its short-term asset management and are looked at by lenders as part of their underwriting process.
Ways To Increase Net Working Capital
Businesses looking to improve their net working capital 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 net working capital.
2. Increase Inventory Turnover
Take a few moments and review your inventory. 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.
Net working capital measures a company’s ability to meet its current financial obligations. When a company has positive net working capital, it means that it has enough short-term assets to pay for its short-term debt and even invest in its growth. Companies can increase their net working capital by refinancing high-interest-rate debt into longer-term and lower-interest-rate loans as well as selling old equipment that’s still in good working condition.