Calculate your organizationʻs net working capital to keep your company in good financial standing.
What is the Working Capital Formula?
Working capital—otherwise known as net working capital (NWC)—is the difference between an organizationʻs current assets and current liabilities. Net working capital measures a company’s short-term financial health; this helps companies understand their current financial situation. NWC estimates are formulated from an inventory of assets and liabilities on a corporate balance sheet.
A positive NWC occurs when a businessʻs current assets outweigh current liabilities. This financial state allows companies to invest and continue to grow. However, if you calculate your organizationʻs net working capital and your company's current assets do not exceed current liabilities, your company could risk bankruptcy.
How to calculate current assets
Current assets include accounts receivable, raw materials and goods inventories, and prepaid expenses. An asset is considered current if it exists on your companyʻs balance sheet and can be converted into cash within one year. Below are examples of current assets.
Cash and cash equivalents
The most obvious liquid asset is cash, which is available for immediate consumption. Cash forms include the following:
Cash
Coins
Money in checking and savings accounts
Money orders
Bank orders
Currency
Cash equivalents are items similar to cash. Examples include the following:
Short-term government bonds
Money market funds
Treasury bills
Stocks
Certificates of deposit
Accounts receivable
Accounts receivable are payments your customers owe for goods or services. These pending payments can be paid via a wire transfer or checks, which are easily converted into cash.
Inventory
Inventory is a business asset meant to be sold by the end of a fiscal year. If the inventory is not sold by the end of the year, the inventory can be liquidated for cash at a lower cost than originally purchased for.
Prepaid expenses
Prepaid expenses are expenses you have paid for but have not been used or received. An example of a common prepaid expense is insurance. Once this expense is paid, businesses remove it from the balance sheet and add it as an expense on the business’s income statement.
How to calculate current liabilities
Current liabilities are the financial obligations (debt) a company must repay within a year. Calculate current liabilities with the following formula:
Current liabilities = (notes payable) + (accounts payable) + (short term loans) + (accrued expenses) + (unearned revenue) + (current portion of long-term debts) + (other short-term debts)
If you are unfamiliar with the terminology used in the formula above, check out these brief definitions:
Notes payable: A written statement from a business to a lender promising to repay them—with interest—on a specified date. Notes payable within one year are considered current liabilities.
Accounts payable: Monetary debts a business owes suppliers/creditors for the products/services received. This includes unpaid vendor invoices.
Short-term loans: Loans a business must repay within a year, business lines of credit, and unsecured short term loans or bank overdraft due within one year.
Accrued expenses: Items a business has recorded on expense reports but has not yet paid for. Once paid, these expenses are no longer considered current liabilities. Examples include rent, salaries, wages, etc.
Unearned revenue: Money a business receives from customers before providing goods or services (such as gift cards).
Current portion of long term debt: Amount of a long-term loan that must be paid off within a year.
Other applicable short-term debts: Any other short-term liabilities that must be repaid within a year and do not fit in the previous categories. This includes credit card debt, taxable income, and salaries payable.
How to calculate net working capital and working capital ratio
Now that you can calculate both current assets and current liabilities for your business, you are ready to use the networking capital formula to determine if your business has enough revenue to cover expenses. Use the following formula to calculate net working capital:
Working capital = (current assets) - (current liabilities)
For instance, if your businessʻs balance sheet has $500,000 total current assets and 100,000 current liabilities, the net working capital for your business would be $400,000.
Net working capital ratio
We calculate assets to liabilities ratios to determine a business’s financial standing. Use the following formula to do so:
Net working capital ratio = Current assets/current liabilities
Remember: two companies with different assets and liabilities could look very similar if only comparing working capital. For instance:
Mollyʻs Milk Co.: Current assets = $700,000; liabilities = $200,000
Janeʻs Writing Co.: Current assets = $900,000; liabilities = $400,000
Both Molly and Janeʻs businesses have a net working capital of $500,000:
Mollyʻs Milk Co.: ($700,000) - (200,000) = $500,000
Janeʻs Writing Co.: ($900,000) - ($400,000) = $500,000
However, Mollyʻs company has a working capital ratio of 3.5, whereas Jane has a working capital ratio of 2.25:
Mollyʻs Milk Co.: (700,000/200,000) = 3.5
Janeʻs Writing Co.: (900,000/400,000) = 2.25
The higher the ratio, the more cash a business has. So, although Molly and Jane have the same net working capital, Mollyʻs business is more financially stable.
Why is net working capital important?
It's important for businesses to utilize the net working capital formula because it enhances a companyʻs understanding of how cash ebbs and flows. Understanding the cash flow of a business is crucial to ensure daily financial obligations are met. Otherwise, your business risks bankruptcy and other financially devastating occurrences.
One of the dire consequences of not keeping track of your cash flow is a loss of investors. After all, investors will not want to allocate resources to a company that cannot pay its bills! Be sure that your business seeks to improve its financial situation so that your organization has the finances to grow over time and impress potential investors.
Net working capital also fuels business operations. Without it, businesses can not make informed financial decisions. Use networking capital to understand the debt capacity of your business. Once the debt capacity of an organization is clearly understood, businesses can not only determine who to invest with, but can also influence negotiations with suppliers. This ensures continuous innovation and improvements.
How to improve net working capital
Once you have calculated your net working capital, you may wonder how to improve it. Start by prioritizing key performance indicators (KPIs) and make sure your employees have access to them. Next, use data analytics to predict future occurrences and avoid risk factors that could be financially devastating.
Prioritize key performance indicators
When a company makes data-informed business decisions, it is more likely to succeed. To improve your companyʻs net working capital, start by ensuring that your team has the ability to access the data they need.
All key performance indicators should be clearly communicated to authorized team members. From here, KPIs should be monitored tightly to highlight potential risk factors that could prevent a business from fulfilling promises to both customers and vendors. Some of the most common KPIʻs for small businesses may include, but are not limited to:
Net income: the money left over after subtracting all expenses and taxes from revenue.
Cash flow: the amount of money moving in and out of a business over a certain frame of time.
Gross profit margin ratio: shows revenue after deducting the cost of goods sold.
Average customer acquisition cost: how much a company spends to add new customers during a certain period of time.
Adopt a data-driven business mindset
Use data analytics to infer future occurrences and make better business decisions. Data analytics is the process of taking raw data and analyzing it to reveal trends and metrics that would otherwise be overlooked by the naked eye. Common data analytics techniques for small businesses may include, but are not limited to:
Regression analysis: a data analysis technique used to estimate how one or more variables might impact the dependent variable, in order to identify trends and patterns.
Monte Carlo simulation: a computerized technique used to generate models of possible outcomes and their probability distributions.
Factor analysis: a data analysis technique used to reduce a large number of variables to a small number of factors, useful for condensing large data sets.
Net working capital is the key to financial success
Calculating net working capital is the first step to understanding your organizationʻs finances. But it’s also important to communicate this information to the rest of your team in order to align department goals. If you are unsure how to relay your company’s finances to your team leaders, check out this article on how to communicate financial information to leaders effectively.