How to calculate net working capital
Net working capital reveals a lot about a company’s ability to meet its obligations. It provides a short-term picture of whether or not a business can cover its bills over the next 12 months. According to a QuickBooks survey, 69% of small business owners are concerned about cash flow. Calculating a company’s liquidity using a working capital formula can help business owners have a better understanding of the financial state of their business to manage short-term obligations.
What is working capital?
According to Tim Berry from SBA.gov, “The goal of business forecasting isn’t about accurately guessing the future. It’s about running your business right.” Net working capital (NWC) forecasts how likely a company is able to cover its current obligations today, next month, and over the next year.
To calculate NWC, a simple working capital formula of current assets minus current liabilities will give you a good idea of the state of liquidity of your business. In most cases, the more working capital a company has available, the less financial strain it will experience.
How to calculate net working capital using a net working capital formula
Working capital is one of the easiest measures of a company’s financial health to calculate. Take a look at your company’s balance sheet and use the following working capital formula to calculate how much working capital your business needs:
Current assets - current liabilities = net working capital
For example, let’s say Company Z’s balance sheet shows liquid assets of $200,000 cash in its bank accounts. Another $200,000 is owed to the company as accounts receivable. And the balance sheet lists $1 million in inventory and equipment. Together, these amounts put the company’s current assets at $1.4 million.
Now let’s say the company owes $500,000 in accounts payable, $200,000 in short-term debt due in the next year, and $100,000 in accrued liabilities like payroll taxes and loan interest due. This means the company’s current liabilities are $800,000.
Using the working capital formula, subtract the company's current liabilities of $800,000 from its current assets of $1.4 million. Company Z has a positive net working capital of $600,000—meaning it has enough money to cover obligations over the short-term.
Sometimes—for simplicity purposes—this is represented as a ratio rather than a dollar value (its working capital ratio). You calculate this by dividing a company’s total assets by its total liabilities. A ratio greater than one means the company can cover its obligations over the short term, while less than one means the opposite. In Company Z’s case, it has a working capital ratio of 1.75 ($1.4 million in assets over $800,000 in liabilities).
According to the Chamber of Commerce, an optimal current ratio is any amount above 1. So, in our case, Company Z is running optimally and has enough reserves to pay its current debts. But some companies need higher net working capital ratios than others.
Businesses with faster inventory turnover have lower ratios. Grocery stores or discount retailers normally do business on a cash basis as a dollar in, dollar out operation. They require less working capital because they turn over product faster. In these cases, the working capital ratio is 1 or less.
The International Journal of Business and Finance Research released the typical working capital ratio by industry. The retail industry’s ratio is 1.52, the service industry’s current working capital ratio is 1.28, and production comes in at 1.41, according to a report by the International Journal of Business and Finance Research.
In our case, Company Z’s liquidity is above average for any of the three industries mentioned. (You can also find typical working capital ratios for other industries in that report.)
You can use the working capital formula to forecast the dollar value you need in assets to meet obligations or to determine if your short-term debt is too high. You can also use an online working capital calculator for more complex calculations. There are also free tools like this net working capital Excel template from the Corporate Finance Institute.
Why is knowing net working capital important?
Knowing ahead of time if a business can meet its obligations over the next few months is crucial to a company’s survival. Typical short-term obligations come in the form of expenses to keep the lights on—such as paying employees, vendors, or even actual lights. Businesses want to address any cash flow issues before they disrupt any operations .
How to increase your net working capital
Using the net working capital formula will quickly tell you if your company has the funds necessary to cover short-term expenses. If the forecasts don’t look good, you can take action before things go wrong. Here are five solutions to negative net working capital.
1. Access additional funds
A company’s net working capital isn’t always steady from month to month. Some companies have higher-expense periods combined with lower-income months Financial ebb and flow is typical in retail businesses where certain events, times of the year, and seasons cause spikes in sales or a drop in business.
Having access to temporary funding can be helpful to a business to navigate these periods. Company credit cards like the Brex Corporate Card that require no personal guarantees, offer higher credit limits with no interest or fees, and provide instant approval are an excellent option. A business line of credit can also provide funding in months when a company needs access to capital.
For longer term funding, a traditional business loan may be a solution. There are alternative funding options beyond bank loans. For example, small business owners can get advances on unpaid invoices. Alternative lenders may offer fewer financing requirements and deliver a faster funding time in exchange for a higher interest rate on the loan.
2. Reduce short-term debt
Businesses can also reduce short-term debt by converting it into long-term debt. Negotiating longer terms can ease the cash flow crunch. According to the SBA, turning to suppliers for longer credit terms is a good solution. Some suppliers recognize the importance of partnerships and may be willing to extend terms to a company they have a long-term relationship with if the business is having temporary liquidity issues.
The SBA recommends longer-term payables—for example, buying inventory and raw materials using the best or longest terms of credit possible—which can be considered a source of interest-free financing.
3. Raise cash by selling assets
Selling business assets like equipment, vehicles, and machinery is one of the fastest ways to raise cash, as long as the physical property doesn’t affect your company’s operations. In some cases, it may be a better financial decision to liquidate certain equipment and lease machinery or equipment instead.
4. Turn inventory over faster
Selling inventory faster may provide the liquidity necessary for some companies with larger amounts of inventory. Business owners can turn inventory over faster by having clearance sales, lowering product prices, or by returning unsold inventory back to a vendor for a refund or credit.
5. Collect on outstanding accounts receivable
The SBA warns that when your business sells products and services on credit, you essentially become a lender. Collecting on outstanding accounts receivable is vital to keep a business running properly. A sale is not complete until you’ve been paid.
Stay on top of customers with past-due invoices and consider offering a small invoice discount if they pay quickly. Be more careful of which individuals and companies you extend credit to in the future to safeguard your net working capital.
Net working capital is the lifeline of a business
A business requires short-term liquidity to meet its obligations and to have the ability to fund long-term goals. Always be mindful of your working capital ratio to stay ahead of any changes in your company’s cash flow. Being able to meet shortfalls before they happen is one of the keys to a company’s long-term success.