What is net working capital?

What is Net Working Capital?

Net working capital is a financial metric that can determine a company’s short-term liquidity and ability to manage assets and debts effectively. This article shows you how to calculate the working capital formula. Additionally, you’ll learn some practical tips to achieve positive net working capital for your business.

When it comes to operating and growing a business, there are several areas you need to keep an eye on as a business owner. One of them is the working capital. In business financing, a company with a robust net working capital represents its capacity to use its assets to grow its business after all liabilities are covered.

For most founders, making a profit is usually their main focus when measuring their business success. While the idea is not inherently wrong, the ability to quantify how well a company manages its funds and debts regularly is just as important. Before we dive into calculating your net working capital, let’s first learn what it is and how it helps companies get an overview of their financial health.

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Net Working Capital Explained

Net working capital (NWC) or simply, working capital is a financial metric that measures the difference between a company’s current assets and its operating or current liabilities on the balance sheet.

Current assets include:

  • Cash
  • Inventories or stocks
  • Accounts receivables (customers’ outstanding bills)
  • Trading securities (treasury bills, government bonds, etc.)
  • Prepaid Expenses (prepaid rents, prepaid insurance, etc.)

As for current liabilities, these are the examples:

  • Accounts payable (amount owed to suppliers or vendors)
  • Payroll
  • Sales taxes
  • Income taxes
  • Customer deposits
  • Short-term loans
  • Customer deposits
  • Long-term debt maturities (a portion of the long-term debt due in 12 months)

Essentially, the working capital indicates the liquidity of a company or its ability to quickly convert assets into cash. It also measures whether or not a company can afford to fund its operations while meeting its short-term obligations. The idea here is to have more assets than liabilities to ensure a good working capital position.

Calculating Working Capital

Net Working Capital Formula

There are different ways to calculate the net working capital. It depends on the accountant on which items to include or exclude. This is the working capital formula:

Current Assets – Current Liabilities = Net Working Capital

For example, if the total current assets of XYZ Company amount to $500,000 and its current liabilities are $100,000. Then its working capital will be $400,000. Additionally, It’s important to note that current assets are any assets acquired within 12 months. On the other hand, current liabilities are items due within 12 months.

Is Net Working Capital important?

Short answer—yes, it’s important. Working capital is not just another line to a balance sheet. It gives you an overview of a company’s operational efficiency, liquidity, and ultimately, its short-term business health.

So, if the net working capital is positive, then it means that the short-term funds from its current assets are more than enough to settle any current liabilities as they come due. Let’s say a company’s account receivable terms are shorter than their payment receivables. This means that a company can collect money from customers before they need to pay their vendors.

In contrast, a negative working capital indicates that the company does not have adequate funds available to pay off its current liabilities. In this case, the company will be unable to pay its creditors on time and may be on the brink of bankruptcy.

Moreover, it helps decision-makers estimate the company’s ability to expand its business quickly. If it has sufficient cash reserves, then it has enough money to scale up their growth. The net working capital numbers are more useful when viewed as a trend line on a graph. It will show a steady improvement or decrease of the working capital over time.

How to efficiently manage working capital?

If your company has a hard time keeping its net working capital afloat, there are strategies to help you without resorting to loans. Here are some tips to follow:

Improve inventory turnover

Keep in mind that stocking up on inventory is tied up with your cash. So, if your inventory management process is slow or products don’t sell out quickly, then you’ll have little working capital to work with.

For slow-moving items, give some discounts and improve the restocking method. This way, you get more inventory out to retailers and customers. Don’t order more than what’s needed. Prioritize fast-selling items on slow months. Regularly review your inventory list and check if there are products with low demand or sales.

Sell long-term assets in exchange for cash

Machineries and buildings are examples of long-term assets. To increase your working capital, consider selling unused items such as office equipment. Another option is to lease available building space. Doing so will beef up your NWC since after all, cash is a current asset.

Refinance short-term debts

Short-term debts are types of loans that are payable in one year or less. Hence, this debt is classified as a current liability. When you refinance a short-term loan into a long-term loan, you extend the payment terms and reduce the monthly payments. This allows you to boost cash for the net working capital. Since long-term debts (longer than one year) fall under long-term liabilities, we don’t factor them into the working capital formula.

Managing your Startup’s Financial Health

To summarize, net working capital demonstrates whether or not a company can meet its financial goals and obligations. A positive working capital means that the company’s short-term assets are enough to pay off its short-term debts. Also, it is an indication that the company is financially ready to invest in its expansion.

For this reason, businesses should focus on improving their working capital by growing their current assets and minimize liabilities. The practical tips we shared in this article should help you track your company’s cash level and meet your debt requirements so you can reach a positive net working capital.

Here at Full Scale, we dedicate our time helping startup founders manage their resources efficiently. Full Scale co-founders, Matt DeCoursey and Matt Watson are startup luminaries who can mentor you to successfully grow a profitable business.

Get in touch with our team today to receive your FREE consultation with the Matts.