Net working capital is a liquidity ratio which shows whether a company can pay off its current liabilities with its current assets. It’s an important metric for management, creditors and company vendors because it measures the financial health of the company – in particular, the short-term liquidity and the ability to use company assets efficiently.
The net working capital formula is very similar to the working capital ratio and is used for current liabilities such as the company’s trade debts, accounts payable and any vendor notes set for repayment in the current year.
How does it measure the financial health of a company? Well, if the company can’t pay off its debts with current assets, management may be forced to use long-term assets, or any income product assets, to pay the debts.
This is a problem because selling those types of assets can affect the performance of the business and lead to reduced operations, lower sales volumes etc and it can also be an indicator of more serious organizational problems.
Net Working Capital Formula
The net working capital formula is a very simple calculation which subtracts the current liabilities from the current assets, leaving you with your net working capital.
The current assets and liabilities are often found on the company balance sheet, but sometimes the balance sheet doesn’t separate current and non-current assets.
Current assets that would be included in the net working capital calculation are:
- Cash and cash equivalents
- Accounts receivable
- Stock inventory
- Short-term investments
Current liabilities would include:
- Accounts payable
- Unearned revenue
- Taxes payable
- Accrued expenses
- Trade debt
In certain cases, you may also choose to include the current portion of long-term debt with current liabilities.
Although it’s a long-term obligation, the current portion of that debt needs to be repaid within the current year, so it makes sense to include it with other obligations that need to be met in the current year.
Working Capital Ratio
Another useful metric is the working capital ratio, which measures the current assets against the liabilities.
The net working capital is an absolute amount, but the working capital ratio gives a number which can be used to quickly get a view on whether the company has enough assets to pay debt.
A working capital ratio higher than 1 means that the company can pay current debt with their current assets.
Working Capital Turnover Ratio
This is another formula which looks at the relationship between net working capital and net sales to see how efficient the company is.
To calculate your average working capital, sum up the net working capital at the beginning of the year and end of the year and divide that by 2.
When a company has a high working capital turnover it means they are generating more revenue per $1 of investment and is a good thing.
Net Working Capital Analysis
It should go without saying that a positive net working capital is more favorable for a company. When you are net working capital positive you can show both creditors and your investors that the company is able to pay its debts with current assets – if needed.
A significant net working capital positive also indicates that the company has the available capital to invest for further growth without the need for additional funding.
That said, if the current assets are too high in relation to the current liabilities it would reduce the working capital turnover of the company, and this could be an indication that the company is not using its assets as efficiently as it could be.
Negative Net Working Capital
When you have a negative net working capital, this says to investors and creditors that the company is not producing enough capital to pay its current debts.
Over time, this could result in the business needing to sell some of the long-term or income-producing assets they have to pay for current debts – like salaries, for example.
The company would also be unable to invest in growth without taking on more debt or investors and, over a long enough period, a negative trend of net working capital can lead to bankruptcy.
Net Working Capital Example
Okay, let’s take a look at Frankie’s Pizzaria. Frankie owns a pizza place and has the below current assets and liabilities:
- Cash: $5,000
- Accounts Receivable: $2,000
- Stock (pizza ingredients): $5,000
- Accounts Payable: $3,000
- Accrued Expenses: $1,000
So the first thing we need to do is get a total of all of the current assets and liabilities:
Now that we have those, we can run the net working capital formula:
Frankie has a healthy, positive net working capital and a good ratio of 3. What this means is that he can easily pay his current debts using only his current assets. The pizza place is very liquid and in good financial shape.
In fact, Frankie could use the liquidity of the business to continue growth by opening another pizza place or expanding the product offering to include burgers and hot dogs.
Net Working Capital Calculator
You can use the net working capital calculator below to work out your net working capital and ratio.
FAQs
1. What is net working capital?
Net working capital is the difference between current assets and liabilities. It's a measure of how much capital a company has within its operating cycle.
2. How do you calculate net working capital?
To calculate the net working capital, use the following formula:
Net Working Capital= Current Assets (CA) – Current Liabilities (CL).
3. What is a good net working capital ratio?
A net working capital ratio of 3 or more is considered good.
4. Do you include cash in net working capital?
No, you do not include cash in net working capital. It is a measure of current assets and liabilities excluding cash.
5. Can net working capital be negative?
Yes, net working capital can be negative if current liabilities are higher than current assets.
