What is Net Working Capital and How is It Calculated
Net Working Capital
Net working capital is a financial metric a business owner should use in order to help measure the cash and operating liquidity position of the business. It is the sum of all current assets and current liabilities. It is a measure of the short-term liquidity of a business, and can also indicates the ability of company management to utilize assets in an efficient manner.
Net working capital can also be used to determine of a company is in a position to grow fast.
If the business has substantial cash in its reserves, it may have enough to scale the business rather quickly. On the other hand if the business has very little in cash reserves than it's highly unlikely that the company has the resources to scale quickly.
It is an important metric to management, vendors and general creditors because it shows the firm's short-term liquidity and ability to pay off its current liabilities with current assets.
The net working capital metric is directly related to the current, or working capital ratio, so called because if a company as more short-term assets than liabilities it can "work". The current ratio is a liquidity and efficiency ratio that measures a firm's ability to pay off its short-term liabilities with its current assets. If you look at the calculation of the current ratio, you see that you use the same balance sheet data to calculate net working capital.
Calculating Net Working Capital
Here is the calculation for Net Working Capital: Current Assets - Current Liabilities = Net Working Capital.
If a business firm has current assets of $200 and current liabilities of $100, then:
- Net Working Capital = Current Assets - Current Liabilities
- =$200 - $100
- =Net Working Capital=$100
This firm can pay its short-term debt obligations and still have $100 left over as a cash or operating liquidity cushion. It has twice the current assets ($200) as current liabilities ($100).
Compare this to the current ratio. If you calculate the current ratio for this example, you would use the current ratio formula:
- Current Ratio = Current Assets/Current Liabilities
- $200/$100 = 2.00X
- Current ratio = 2.00X
You can see the relationship between the two financial metrics.
Examples of Net Working Capital
Of course, changes to either assets or liabilities will cause a change in net working capital, unless they are equal. For instance:
If a business owner invests an additional $10,000 in their company, the assets increase by $10,000 but current liabilities do not increase. Thus, working capital increases by $10,000.
If that same company were to borrow $10,000, and agree to pay it back in 90 days, the working capital has not increased, because both assets and liabilities increased by $10,000.
Should that same company invest $10,000 in inventory, working capital will not change because cash decreased by $10,000, but assets increased by $10,000.
The same company sells a product for $1,000, which is in inventory at a cost of $500.
Working capital increases by $500 because accounts receivable, or cash, increased by $1,000 and inventory decreased by $500.
The company now uses $1,000 to buy equipment. That will reduce working capital because the asset Cash decreased.
Cash management and the management of operating liquidity is important for the survival of the business firm. A firm can make a profit, but if they have a problem with their cash position, they won't survive. This is why it is important for a business owner to use all the financial metrics and measures available to manage liquidity and cash.