Net working capital, sometimes known as NWC, is used to gauge your business’s financial health. However, it’s not always necessary to have a large amount of net working capital, and sometimes even dipping into the negative is acceptable. Below, we’ll break down how to find net working capital, the calculations involved, and what it really means for your business.
What is Net Working Capital?
Simply put, net working capital is a measure of your business’s short-term liquidity, operational efficiency, and to some degree, short-term financial health. It refers to the difference between your company’s total current assets and total current liabilities.
What is Included in Net Working Capital?
If you’re following proper accounting procedures, you’ll use the following line items from your balance sheet:
Current Assets: By definition, you should only include short-term assets that will be converted into cash within the next 12 months. That includes physical cash and cash equivalents, inventory, accounts receivables (invoices your customers need to pay), prepaid expenses, marketable investments or securities (stocks, bonds, etc.), and any other liquid assets.
Current Liabilities: Again, you’ll want to work specifically with short-term financial obligations—items you’ll be responsible for taking care of within the next year. Examples of liabilities include accounts payables/ trade debts (invoices you need to pay), short-term loans/debts, interest, and taxes (payroll, income, sales).
How to Calculate Net Working Capital
The net working capital (NWC) formula is simple: Net Working Capital = Assets – Liabilities.
1. Add Up The Company’s Current Assets
First, add up all your current liquid assets and anything that will become liquid within the next year.
2. Add Up The Company’s Current Liabilities
Then, follow the same process for your liabilities.
3. Calculate Net Working Capital
Subtract your liabilities from your assets. The answer you calculate will be your net working capital.
For example, let’s say your current assets total $200,000, and your short-term liabilities total $50,000. So your net working capital is $150,000.
Positive vs. Negative Net Working Capital
With those figures in hand, a clearer picture of your company’s health begins to emerge.
- Negative Net Working Capital: Your company can’t meet all its current expenses if you have negative working capital. That might not be a huge problem in the long run if you don’t usually run in the negative, just make a large purchase that will fuel your business and have a clear path to positive. Still, outside specific circumstances such as this, it typically means a business could wind up in bankruptcy.
- Positive Net Working Capital: When your net working capital is positive, it usually means you’re in a good spot financially or at least headed in the right direction. However, further calculations are necessary to help determine your fiscal strength and if your business is making the most of its available capital.
What’s the Difference Between Working Capital and Net Working Capital?
Often, “net working capital” is simply shortened to “working capital,” and they can be taken to mean the same thing. However, they shouldn’t be confused with “gross working capital,” which considers the company’s assets but not its liabilities.
For example, let’s say your company takes out a $100,000 loan, the cash is sitting in your bank account now, and it’s due in six months. If you’re looking purely at your gross working capital, you have $100,000 in assets. Suppose you’re looking at net working capital or working capital. In that case, you’ll not only be taking into account that the $100,000 is due in your liabilities, effectively canceling it out, but you’ll also be including any interest or fees associated with the loan that you need to pay. Net working capital gives you a much clearer picture of where your company sits.
What is Net Working Capital Ratio?
Another net working capital calculation often used is the net working capital ratio, also referred to as the “current ratio.” It’s a quick way to determine if your net working capital is ideal, less than ideal, or if your company is potentially in the danger zone.
How to Calculate Net Working Capital Ratio
The equation to calculate your net working capital ratio is also straightforward: Net Working Capital Ratio = Assets / Liabilities.
We’ll use the same figures as before as an example. Your assets are $200,000, and your liabilities total $50,000. The calculation is 200,000 / 50,000 = 4
What’s a “Good” NWC Ratio?
There aren’t necessarily good or bad net working capital ratios, but there are some guidelines that can help paint a clearer picture of where your company sits.
- A Net Working Capital Ratio of <1: Even though you have positive working capital, your company is in a risky position if your net working capital ratio is less than one. At this stage, an unexpected expense or late payment could land you in the negative and leave you unable to pay your bills.
- A Net Working Capital Ratio of 2+: In the earlier example, the net working capital ratio was four. Perhaps the numbers looked good on paper—you’ve got positive free cash flow—but anything greater than two really means you’ve likely got money sitting around that could be used to fuel the growth of your company. An example of this would be holding onto too much inventory, where funds could have been used more effectively.
How to Calculate Change in Net Working Capital
In the cash flow financial statement, the Change in Net Working Capital (NWC) section shows how operating assets and operating liabilities change over time. Having a positive change in NWC means the company collects and holds onto cash earlier. Negative NWC, on the other hand, may mean that the company must spend cash before it can deliver its products and services.
Change in Net Working Capital Formula
On the cash flow statement, changes in NWC are crucial to track because the monitoring of these changes over time (e.g. annually or quarter-over-quarter) helps determine the extent to which a company’s free cash flows will deviate from its accrual-based net income (“bottom line”). The current period’s net working capital (NWC) balance is subtracted from the prior period’s NWC balance to calculate the change in net working capital (NWC).
Change in Net Working Capital (NWC) = Prior Period NWC – Current Period NWC
Why is Net Working Capital Important?
Once you become familiar with net working capital, you can tell a lot about your company from your calculations.
- Current Liquidity: Looking at a snapshot of where your business sits here and now will tell you if you can meet all your short-term obligations.
- Trends: If you consistently see positive net working capital and climbs over time, it suggests that your business is healthy, growing, and will be able to meet its obligations in the future. If it’s negative or has been declining, you’ll want to investigate the decrease to see if there are any adjustments you can make to improve it.
- Growth Opportunity: If your net working capital is high, it’s generally a sign that you can put more cash toward things that will help your company grow, like expanding into new markets, creating a new product, or purchasing new equipment.
How to Improve Net Working Capital
Even if you know why your net working capital is low or negative, and even if you have a valid reason, it’s still a good idea to do everything you can to correct it in order to meet your current financial obligations. A few ways small business owners can improve net working capital include:
- Change Your Payment Terms: Often, small businesses give their customers 30, 60, or 90-day payment terms. If possible, shorten your terms to get cash flowing in faster. You can also charge a late fee for delinquent payments but be sure to notify your customers of the policy change well in advance.
- Chase the Dollar: Send your customers a reminder of their impending due date a few days before their payment is due. Give them additional reminders after the deadline has passed.
- Speed Your Working Capital Cycle: Explore ways to make your business operate more efficiently, so there’s less time between purchasing your raw goods and getting paid for the finished product or service.
- Request Better Terms from Vendors: Ask your vendors for longer payment terms, discounts, or other benefits that can boost your bottom line.
- Minimize Overhead: Search for ways to cut expenses. You may need to change suppliers/vendors, refinance debts with high-interest rates, or find other ways to reduce your operating expenses.
- Maximize Investment Returns: Make sure you’re getting the best return you can from any investments your company has.
Invoice Factoring Can Help
Companies in B2B industries have another ace up their sleeve—invoice factoring. It may be the ideal solution for your business if you’re looking at options like changing your payment terms or are not having luck getting customers to pay in a timely manner. Like those options, factoring can help speed up your cash conversion cycle, so you get paid faster.
However, factoring doesn’t rely on your customers changing anything. Instead, you simply sell your unpaid invoices to a factoring company. The factoring company pays you right away and then waits for payment from the customer. There’s no debt or interest to pay back, so it doesn’t lower your net working capital, and you can put that money to use for your business right away. To find out if you qualify, apply to factor with Viva Capital.
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