Here’s how to calculate net working capital, how to use the information, and some strategies for improving a lackluster result.
What Is Net Working Capital?
Many people use net working capital as a financial metric to measure the cash and operating liquidity position of a business. It consists of the sum of all current assets and current liabilities. Net working capital measures the short-term liquidity of a business, and can also indicate the ability of company management to utilize assets efficiently.
How Do You Calculate Net Working Capital?
To calculate a business’s net working capital, use the balance sheet to find the current assets and current liabilities. Combined, these two figures give you the net working capital. Since liabilities are amounts owed by a business, this is usually expressed as a subtraction equation.
How Net Working Capital Works
The amount of net working capital a company has available can be used to determine if the business can grow quickly. With substantial cash in its reserves, a business may be able to quickly scale up. Conversely, if the business has very little in cash reserves, then it’s highly unlikely that the company has the resources to handle fast-paced growth. Management, vendors, and general creditors watch a company’s net working capital because it provides a snapshot of the firm’s short-term liquidity and ability to pay off its current liabilities with its current assets.
What Affects Net Working Capital?
Changes to either assets or liabilities will cause a change in net working capital unless they are equal. For example, if a business owner invests an additional $10,000 in their company, its assets increase by $10,000, but its current liabilities do not increase. Thus, working capital increases by $10,000. If that same company were to borrow $10,000 and agree to pay it back in less than one year, the working capital has not increased—both assets and liabilities increased by $10,000. Should that same company invest $10,000 in inventory, working capital will not change because cash decreased by $10,000, but assets increased by $10,000. The same company sells a product for $1,000, which it held in inventory at a value of $500. Working capital increases by $500 because accounts receivable or cash increased by $1,000 and inventory decreased by $500. The company now uses $1,000 to buy manufacturing equipment. That will reduce working capital because current assets (cash) decreased, but the equipment has more than a one-year life, so it falls under long-term assets instead of current assets.
Increasing Net Working Capital
If your business has difficulty meeting its financial obligations and needs more net working capital, there are a few strategies that can help free up cash and increase working capital.
Sell long-term assets: If your business has long-term assets such as buildings or equipment, consider selling off unused equipment or subleasing unused building space. This will boost cash, which is a current asset, so your net working capital will increase. Some companies sell their own commercial buildings to generate cash and subsequently lease the facilities back from the new owner at a payment that fits within their budget—this allows them to focus cash on other areas of the business.Increase the speed of inventory turnover: Holding months’ worth of inventory ties up cash. If you have slow-moving products or an inefficient inventory management process, your business could have little working capital. Discount slow-moving items and revamp your company’s restocking procedures to get inventory out to customers or retailers more quickly. Focus on fast-selling inventory and don’t over-order, especially during slow-selling times of the year. Review your list of inventory items and reconsider spending on items that have low demand or infrequent sales.Refinance short-term or expensive debt: Short-term debt refers to loans that will be paid in one year or less, and these debts fall under the current liabilities category. Refinancing short-term loans with long-term debt can stretch out payment schedules and lower monthly payments, providing more cash for working capital. Long-term loans fall under the balance sheet’s long-term liabilities section, so they don’t factor into the working capital calculation.
The Current Ratio
Net working capital is directly related to the current ratio, otherwise known as the working capital ratio. The current ratio is a liquidity and efficiency ratio that measures a firm’s ability to pay off its short-term liabilities with its current assets. You’ll use the same balance sheet data to calculate both net working capital and the current ratio. The difference is that, whereas the net working capital is a subtraction equation, the current ratio is a division equation. Instead of subtracting the current liabilities from the current assets, you divide current assets by current liabilities. A current ratio of one or more indicates that the company can cover its obligations for the next year. A ratio above two, however, might indicate that the company could benefit from managing its current assets or short-term financing options more efficiently.
Limitations of Net Working Capital
If a company stretches itself too thin while trying to increase its net working capital, it could sacrifice long-term stability. For example, refinancing short-term debt with long-term loans will increase a company’s net working capital. However, long-term loans can be much more expensive than a short-term loan. Refinancing too much debt this way could lead to massive debt costs in the long-term, potentially putting the company on unsteady financial footing. From an analyst’s perspective, this is why it’s important to balance the net working capital with another measurement that accounts for long-term finances. The debt-to-equity is one such measurement—it compares company ownership to total debt.
