Imagine you run a small but thriving retail store. Orders are pouring in, and your sales numbers are impressive.
However, there's a persistent problem: despite the strong revenue, you frequently struggle to pay suppliers on time and cover payroll.
The key to resolving this issue is a deep understanding of net working capital (NWC). By regularly calculating and monitoring NWC, business owners can prevent cash shortages and ensure they have enough liquid assets to cover immediate expenses.
In this blog, we'll review what the formula for net working capital is and how a cash flow projection app can help manage your business’ financial health.
What is Net Working Capital (NWC)?
Net working capital (NWC) is a financial metric that reveals what's left after a company pays off its short-term debts.
When you subtract current liabilities from current assets, you get a clear picture of a company's capacity to fulfill its short-term financial commitments and highlight the liquid value available for day-to-day operations.
Here's a quick summary that outlines the different types of operating current assets and liabilities:
| Category | Type | Definition |
|---|---|---|
| Operating Current Assets | Cash | The most liquid asset, readily available for use. |
| Accounts Receivable | Money owed to the company by customers for goods or services delivered on credit. | |
| Inventory | Goods available for sale or raw materials that can be converted into finished products. | |
| Marketable Securities | Investments that can be quickly sold for cash. | |
| Prepaid Expenses | Payments made in advance for future goods or services, such as rent or insurance. | |
| Operating Current Liabilities | Accounts Payable | Money the company owes to suppliers for goods or services received. |
| Short-Term Loans | Loans and other forms of indebtedness fall due within the next twelve months. | |
| Accrued Liabilities | Expenses incurred but not yet paid, such as wages, taxes, and interest. | |
| Other Short-Term Obligations | Any other debts or obligations that must be paid within the year. |
How Does Net Working Capital Differ from Working Capital?
While both terms are often used interchangeably, they serve different purposes and provide unique insights.
- Working Capital gives a broad view of a company’s overall liquidity and operational efficiency. It's like a general health check for your business, ensuring you have enough assets to cover both regular and unexpected expenses.
- Net Working Capital offers a more focused view, emphasizing the actual liquid cash available after short-term debts are paid.
| Working Capital | Net Working Capital | |
|---|---|---|
| Formula | Current Assets - Current Liabilities | Current Assets - Current Liabilities |
| Includes | Cash, accounts receivable, inventory, marketable securities, prepaid expenses. | Same as working capital, but it emphasizes the net amount available after short-term debts. |
| Key Focus | Overall liquidity to manage daily operations. | Specific businesses’ short-term liquidity after debts are paid, ensuring smooth operation. |
| Implications | Helps determine if the company can manage daily operations and unforeseen expenses. | Indicates if the company can cover its short-term debts and continue operating smoothly. |
Why is NWC Important?
Applying the formula of net working capital helps businesses stay financially healthy and ready for growth opportunities. Here's why it matters across different industries:
- Retail Industry: Ensures shelves are stocked and meets seasonal demand spikes.
- Manufacturing Industry: Keeps production lines running smoothly and avoids production halts. Effective management of manufacturing cash flow is crucial to ensuring that raw materials are available and labor costs are covered without disrupting operations.
- Technology Industry: Funds development and marketing efforts upfront, supporting innovation.
- Healthcare Industry: Ensures the availability of medical supplies and timely patient care.
- Hospitality Industry: Manages daily operations and covers unexpected expenses during peak seasons.
- Construction Industry: Maintains cash flow to pay for materials and labor without delays.
Pros and Cons of Net Working Capital
If, after using the net working capital calculation formula, your result shows a high NWC, it indicates that your business has a solid financial cushion.
However, it can also indicate that resources aren't being used efficiently, potentially tying up funds that could be better invested elsewhere.
Here's a detailed overview of the benefits and drawbacks of a high NWC:
| Aspect | Pros | Cons |
|---|---|---|
| Profitability | Allows reinvestment in operations, potentially leading to higher profits. | Excess liquidity can mean missed opportunities for higher returns. |
| Operational Efficiency | Ensures smooth daily operations without interruptions. | May indicate excess inventory or receivables, tying up capital. |
| Financial Stability | Provides a buffer for unexpected expenses or revenue drops. | High NWC might result in missed investment opportunities. |
| Growth Potential | Facilitates investment in growth opportunities, like expanding operations. | Risk of overstocking, leading to increased storage costs and potential obsolescence. |
| Creditworthiness | Enhances creditworthiness, allowing better negotiation terms with suppliers. | Managing high NWC can lead to inefficient cash management. |
What is the Net Working Capital Formula?
The equation for net working capital is straightforward with the following formula:
Net Working Capital = Current Assets minus Current Liabilities
How to Calculate Net Working Capital
Here's a step-by-step guide on how to find net working capital based on the sample data below:
- Cash: $1.2 million
- Total Inventory: $800,000
- Short-term Investments: $70,000
- Accounts Receivable: $600,000
- Accounts Payable: $700,000
- Other Current Liabilities (wages, interest, etc.): $1.1 million
1, Add up all current assets
| Current Assets | Amount |
|---|---|
| Cash | $1.2 million |
| Total Inventory | $800,000 |
| Short-term Investments | $70,000 |
| Accounts Receivable | $600,000 |
| Total Current Assets | $2.67 million |
- Subtract accounts payable
| Amount | |
|---|---|
| Total Current Assets | $2.67 million |
| Accounts Payable | $700,000 |
| Difference After Accounts Payable | $1.97 million |
- Use the formula for networking capital and deduct other current liabilities
| Amount | |
|---|---|
| Difference After Accounts Payable | $1.97 million |
| Other Current Liabilities | $1.1 million |
| Net Working Capital | $870,000 |
- Evaluate the results
Evaluate what this net working capital means for the company:
- Positive NWC: With $870,000 more in current assets than in current liabilities, the company can comfortably cover its short-term debts and has additional funds for growth opportunities.
- Zero NWC: This would mean the company can meet its current obligations but has no surplus for unexpected expenses or investments.
- Negative NWC: If the result were negative, it would indicate the company needs more funds and might have to borrow or raise money to cover its expenses and financial obligations.
Positive vs Negative Net Working Capital
As previously mentioned, a positive NWC shows that a company can easily cover its short-term debts and invest in growth. Conversely, a negative NWC signals potential cash flow problems and the need for external financing, highlighting exactly why businesses need finance to maintain stability and drive growth.
Net Working Capital Example
Let's look at two scenarios using a sample company, Green Valley Grocers, to better understand the impact of having a positive and negative NWC.
Positive NWC
Imagine Green Valley Grocers has $500,000 in current assets (cash, inventory, and accounts receivable) and $300,000 in current liabilities (accounts payable and short-term loans).
Net Working Capital = $500,000−$300,000= $200,000
With a positive NWC of $200,000, the store has enough resources to cover short-term obligations, manage daily operations, and invest in growth opportunities, ensuring financial stability.
Negative NWC
Now, suppose Green Valley Grocers has $250,000 in current assets and $400,000 in current liabilities.
Net Working Capital = $250,000−$400,000= −$150,000
With a negative NWC of -$150,000, the store may struggle to meet short-term obligations, face liquidity issues, and need external financing, limiting its ability to grow and operate smoothly.
Net Working Capital Ratio
The net working capital ratio shows what portion of a company's assets are available as cash or other liquid assets to cover short-term expenses. Expressed as a percentage, it helps understand how much of the company's total assets are tied up in net working capital.
Net working capital ratio = (current assets minus current liabilities and expenses) divided by (total assets)
How to Calculate Net Working Capital Ratio
Suppose a company has current liabilities of $2.1 million, current assets of $2.8 million, and total assets of $4 million. Let’s use the net working capital ratio formula to find the ratio percentage:
| Amount | |
|---|---|
| Current Assets | $2.8 million |
| Minus Current Liabilities ($2.1 million) | 700,000 |
| Divided by Total Assets ($4 million) | 0.175 |
| Net Working Capital Ratio | 17.5% |
Example of Net Working Capital Ratio
A ratio above 1 indicates good short-term financial health because it means the company has more current assets than current liabilities.
As shown in the example above, a 17.5% ratio indicates that the company maintains a healthy level of liquidity. This suggests that the company is well-positioned to meet its short-term financial obligations, pay off debts, and cover any unforeseen expenses that may occur.
Conclusion
Think of NWC as your company’s financial safety net—when it's positive, it means you have the resources to cover short-term expenses and invest in new opportunities.
To streamline the management of NWC, consider using user-friendly cash flow forecasting software like Cash Flow Frog.
With Cash Flow Frog, you can effortlessly edit imported data without altering the original data in your accounting software, ensuring flexibility and data integrity.
The best part? The software syncs and updates around the clock, automatically adding new bills, invoices, estimates, and other transactions. This way, all your data stays current and reliable.
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