Last Updated on March 18, 2021 by Grey Idol
Net working capital (NWC) is an organization’s total short-term assets minus its short-term liabilities. An organization’s net working capital paints a picture of its overall financial health and its being run efficiently.
There are a number of ways to calculate net working capital depending on what the person analyzing the data is looking for. This guide will go over the components of net working capital and how to calculate it using a few different formulas.
But first, it might be useful to take a look at what net working capital is used for and why it’s so important.
Why Is Net Working Capital Important?
Net working capital is important because it tells a business’s decision-makers whether or not the business is able to cover all of its expenses.
Whenever possible, a company’s NWC should be greater than zero – otherwise, it means that it’s not able to meet all of its financial obligations, which is a clear sign of a business in trouble.
There are some who believe that a company’s net working capital shouldn’t be too high, though, since a large number of unspent assets could mean that the business isn’t making the most of what it has and pushing as hard as it could be for growth.
Of all markers of a business’s success, net working capital is perhaps the clearest one, especially when viewed over time or in comparison with other companies in the industry.
How to Calculate Net Working Capital
Calculating net working capital isn’t difficult once it’s clear what is being factored into the calculations. Essentially, net working capital is concerned with short-term assets and liabilities, which mean those that will be paid or come due within one year.
As stated above, the net working capital of a business is the difference between these two things.
One can calculate net working capital using all assets and liabilities or just select ones, depending on what the analyst is focused on. In most cases, all will be included, so it’s important to know exactly what aspects of a business constitutes “assets” or “liabilities,” even if it seems obvious at first glance.
A business’s assets include all of its cash and everything it owns. These assets are separated into two groups:
- Long-term assets
- Short-term assets
Long-term assets are things that are hard to liquefy, or turn into cash – they won’t be liquified within the next year. These include things like:
- Long-term investments
- Copyrights and trademarks
Short-term assets, also called current assets, are assets that will be liquified within the next year. Short-term assets include:
- Cash (and cash equivalents)
- Trade receivables (accounts receivable or notes receivable)
- Notes receivable
- Inventory (including raw materials and items in the process of being made)
- Short-term investments
- Marketable securities
- Prepaid expenses (like rent or insurance)
For the purposes of calculating net working security, it’s important to know the difference between long and short-term assets because only short-term assets are factored in – long-term assets are ignored completely.
Simply put, a business’s liabilities are its financial obligations, or money it’s agreed to pay others.
Just like with assets, a business’s liabilities can be short or long-term. Long-term liabilities are things like:
- Deferred taxes
- Retirement and pension obligations
- Deferred revenue
- Bonds payable
Short-term, or current, liabilities are due within a year and include:
- Accounts payable
- Rent and utilities
- Supplies and materials
- Income tax
As with assets, a business only needs to worry about short-term debts when calculating net working capital, ignoring long-term debt altogether.
Calculating business figures can be intimidating, but figuring out a business’s net working capital is actually incredibly easy. Once a business is clear on what its short-term assets and liabilities are, calculating the net working capital is a matter of simple subtraction.
The most straightforward formula for doing this is also by far the most often used:
Short-Term Assets – Short-Term Liabilities = Net Working Capital
This formula takes everything into account for a clear, general overview.
If the company wants to analyze only the free cash flow or operating assets instead of the company’s total assets, the formula would be:
Short-Term Assets (except cash) – Short-Term Liabilities (Excluding Debt) = Net Working Capital
Most businesses use the first formula in general practice, but knowing how to alter the formulas slightly to look at a business’s liquidity from different angles can be helpful, too. A couple more examples of this are net working capital requirement and net working capital ratio.
Net Working Capital Requirement
A near cousin to net working capital is the organization’s net working capital requirement.
Essentially, most companies have to pay suppliers for the goods (or raw materials for goods) that it sells. But there’s naturally a lag time before the company makes money on those goods because it has to wait for customers to pay their invoices.
Net working capital requirement is the amount needed to bridge that gap so that the organization is able to pay its suppliers on time. The formula to calculate this is:
Accounts Receivable + Inventory – Accounts Payable = Net Working Capital Requirement
Net Working Capital Ratio
Like net working capital, a company’s net working capital ratio shows how much money it has to pay for short-term obligations. The net working capital ratio formula is:
Short-Term Assets / Short-Term Liabilities = Net Working Capital Ratio
The ratio will vary between companies and industries, but a healthy range is usually 2:1, meaning that the business has twice as many assets as liabilities. However, depending on the industry, a ratio as low as 1.2:1 may be acceptable.
Below that means the business might not be able to meet upcoming financial obligations. Too high, and it might mean the company isn’t using resources effectively.
Tracking and Managing Net Working Capital
Calculating a company’s net working capital once is an excellent first step, but it’s crucial to the organization’s success that it be tracked over time in order to get a clear understanding of whether the business is becoming more successful over time as well as whether there are certain times of the year when the business is healthier than others.
Net working needs to be managed so that it remains in a healthy range. It can also help decision-makers identify areas where the business operations might improve.
- Collections: How efficiently are accounts receivable being collected? Are there a number of outstanding unpaid customer invoices?
- Debts: Are debts being paid promptly in order to build good relationships and avoid late fees?
- Inventory: How efficiently is inventory being managed? Is there a large surplus sitting on the shelves, or does it move pretty quickly?
Low working capital isn’t good news for a business to get, but finding out sooner than later can give it enough time to get back on track.
As you can see, an accurate measure of an organization’s net working capital is vital to understanding its short-term financial health. Fortunately, it’s also incredibly easy to calculate using a balance sheet and the formulas laid out above.
Keeping track of these measurements on a regular basis is one of the most important things a business can do to ensure a healthy liquidity ratio and keep operating at maximum efficiency.