Net working capital (NWC) is the difference between the current assets and current liabilities of your business. Net working capital is easily calculated using the following simple formula:
Current Assets - Current Liabilities = Net Working Capital
Net working capital gives you and your investors a good snapshot of the financial health of your business. One of the easier accounting formulas to calculate, even entry-level bookkeepers will be comfortable calculating NWC.
Overview: What is net working capital (NWC)?
Net working capital, or NWC, is the difference between the current assets of your business and its current liabilities. To understand the impact and importance of NWC, you first have to understand the following accounting terms:
- Current assets: Current assets are considered short-term assets because they can be quickly converted to cash. Current assets include cash such as your savings and checking accounts, accounts receivable, cash equivalents such as short-term investments and money market funds, inventory, and any prepaid expenses. While equipment, buildings, and land are assets, they are not current assets because they cannot be converted into cash quickly.
- Current liabilities: Current liabilities are short-term obligations such as accounts payable, notes payable, and deferred revenue. Credit cards and short-term loans are also considered current liabilities, since they are due in one year or less. Though real estate loans and mortgages are considered long-term liabilities, the portion due within the year will usually be included in short-term liabilities.
How do you calculate net working capital?
If you’re using accounting software, your current asset and liability totals can be taken directly from your balance sheet. If you’re recording accounting transactions manually, you’ll need to add the appropriate account balances in your general ledger to arrive at current asset and current liability totals.
There are only three steps required to calculate net working capital:
- Calculate current assets: Using the balance sheet example above, you’ll find current assets included in the company assets section with cash, cash equivalents, accounts receivable, inventory, and short-term investments all considered current assets. Based on the balance sheet totals, current assets total $149,000.
- Calculate current liabilities: Current liabilities are located on the balance sheet under the company liabilities and shareholders’ equity section. Current liabilities include accounts payable, notes payable, accrued expenses, and deferred revenue. Payroll and sales tax payable would also be included in current liabilities. Based on the balance sheet totals, current liabilities total $47,000.
- Calculate NWC: Now that you have your current assets and current liabilities balances, you’re ready to calculate net working capital:
$149,000 - $47,000 = $ 102,000
The results indicate that your business has $102,000 available to meet your short-term financial obligations.
Why is net working capital important?
As a business owner, you want to be assured that your business has enough money to cover short-term expenses like rent and payroll. Knowing your NWC can also provide some reassurance that should something catastrophic happen, you have enough short-term assets available to use for emergencies.
In addition, knowing your NWC can give you the confidence to invest in additional income-producing opportunities, while using your NWC can also be helpful when creating financial projections.
Another reason to calculate net working capital on a regular basis is to examine trends over time. Has your NWC increased in the last year, or is it on a downward trend? Knowing how your NWC is trending makes it easier to make informed business and investment decisions.
An upward trend indicates that your business is operating efficiently and is able to meet its current financial obligations, while a downward trend may signal an internal operations issue that needs to be addressed.
What's a good net working capital ratio?
While calculating your net working capital is important, understanding the calculated results is even more important. So, how do you know what a good net working capital is?
Generally speaking, any positive NWC indicates that your business is operating efficiently and is able to cover its immediate financial obligations as well as invest in business growth.
If your NWC is zero, it means you’re able to meet only current financial obligations, but you may have a problem meeting other short-term obligations in the future. A negative NWC can be cause for alarm and usually indicates that you’ll need to raise additional funds or borrow money in order for the business to survive.
If you’re unsure what a good NWC is for your business, be sure to compare your results to similar businesses in your industry. For instance, if you own a computer repair business, be sure to only compare your NWC results to other computer repair businesses.
How to increase net working capital in your business
While decreasing accounts receivable by collecting payments earlier can help with cash flow, that won’t directly impact your NWC, as accounts receivable totals are included in your current assets calculation. However, there are some things you can do to increase your net working capital, including:
- Selling long-term assets: If you have long-term assets that are currently not being used, you many want to consider selling them for cash. This will provide an immediate boost to your NWC by increasing your current assets.
- Refinance short-term debt: If you refinance your short-term debt as long-term debt, it will no longer be considered a short-term liability and will be removed from your NWC since it’s no longer due in less than a year.
- Manage inventory better: While inventory is considered a current asset, it’s more valuable sold than it is sitting in a warehouse. Finding ways to boost sales or better manage your inventory levels to avoid overstocked products can directly impact your net working capital.
Knowing your net working capital is important
If you can create a balance sheet, you can calculate your net working capital. Don’t wait to be surprised; calculate this number on a regular basis.