Net Working Capital Definition
Net working capital is a liquidity ratio that shows whether a firm with its current assets can pay off its current liabilities. It is an important metric for management, creditors, and company vendors because it measures the company’s financial health – in particular, the short-term liquidity and the ability to efficiently use company assets.
The net working capital formula is somewhat similar to the working capital ratio which is used for current liabilities such as the trade debts of the company, the accounts payable, and any vendor notes set for repayment in the existing year.
How does this measure the financial health of a company? Well, if a company can not pay back its debts to current assets, management may be forced to use long-term assets or any income product assets to repay the debts.
This is an issue because selling these types of assets can impact the performance of the business and lead to reduced operations, lower sales volumes, etc., and can also be an indication of more serious organizational issues.
Net Working Capital Formula
The net working capital formula is a very straightforward equation that subtracts the current liabilities from the current assets, leaving you with your net working capital.
Net Working Capital=Current Assets−Current Liabilities
Current assets and liabilities are often identified on the company’s balance sheet, although often the balance sheet does not separate current and non-current assets.
Current assets that should be included in the calculation of net working capital are as follows:
- Cash and cash equivalents
- Accounts receivable
- Short-term investments
- Stock inventory
Current liabilities would include:
- Accounts payable
- Unearned revenue
- Taxes payable
- Trade debt
- Accrued expenses
In some cases, you could also choose to include the current portion of the long-term debt with the current liabilities.
Since it is a long-term obligation, the current portion of that debt has to be repaid in the current year, and it makes sense to include it in other obligations that need to be fulfilled in the current year.
Working Capital Ratio
Another useful metric is the working capital ratio, which measures current assets versus liabilities.
The net working capital is an absolute amount, but the working capital ratio provides a number that can be used to quickly assess if the company has enough assets to pay off the debt.
Working Capital Ratio= Current Assets/Current Liabilties
A working capital ratio of more than 1 means that the company will pay current debts from its current assets.
Working Capital Turnover Ratio
This is another formula that looks at the relationship between net working capital and net sales to see how efficient the organization is.
Working Capital Turnover= Net Sales/Average Working Capital
In order to calculate your average working capital, sum up the net working capital at the beginning of the year and the end of the year and divide it by 2.
If an organization has a high turnover in working capital, it means that it generates more revenue per $1 of investment which is a positive thing.
Net Working Capital Analysis
A positive net working capital should be of course more favorable to a company. You can show both creditors and investors that, if you are net working capital positive, the company can pay its debts with its current assets – if needed.
A significant positive net work capital also indicates that the company has the capital available to invest without additional funding for further growth.
That said, if the current assets are too high compared to the current liabilities, the company’s working capital turnover will be reduced and that could be an indication that the company does not make the most efficient use of its assets.
What is a Negative Net Working Capital?
If you have a negative net working capital, investors and creditors will be told that it does not produce sufficient capital to pay its current debts.
Over time, this will cause a company to sell some of the assets that it needs to pay out for current debts – such as salaries, for example.
The company will also be unable to invest in growth without taking on more debt or creditors, and a negative net working capital trend may lead to bankruptcy over a long period of time.
Change in Net Working Capital
You may ask, “How does a company change its net working capital over time? “There are three main ways in which the liquidity of the company can be improved year on year. First, the company can reduce the collection time of its accounts receivable. Second, it will reduce the amount of inventory carried out by returning non-marketable products to suppliers. Third, the company may negotiate longer terms of payment of accounts payable with vendors and suppliers. Each of these steps will help to improve the company’s short-term liquidity and will have a positive impact on the analysis of net working capital.
Net Working Capital Example
Let’s take a look at ABC Company. The company has the below current assets and liabilities:
- Cash: $6,000
- Accounts Receivable: $1,000
- Stock (products): $5,000
- Accounts Payable: $2,000
- Accrued Expenses: $1,500
Total Current Assets= $6,000 + $1,000 + $5,000 = $12,000
Total Current Liabilties= $2,000 + $1,500= $3,500
Net Working Capital= $12,000 – $3,500= $8,500
Working Capital Ratio= $12,000/$3,500=3.42
Company ABC has a positive net working capital and a good ratio of 3.42. What this means is that he can easily pay his current debts using only his current assets.
In fact, Company ABC could use the liquidity of the business to continue growth by opening another branch place or expanding the product offering to include different products.