Net working capital is like a financial health checkup for a company. It tells us if a business has enough money to handle its daily expenses and to invest in its future. This number can reveal how smart a company is with its money for growth.   

In this blog, we will dive into net working capital, learn how to calculate it correctly, and see why it’s crucial for a company’s financial well-being.     

What exactly is net working capital?  

Net working capital, often abbreviated as NWC, is like a financial health report card for a business. It shows the difference between what a business owns (like cash, goods, and money others owe them) and what it owes to others. This difference measures how easily a business can access its money.  

Net working capital also covers net operating working capital, which is the difference between a company’s current operating assets and what it owes for running the business. To calculate net working capital and net operating working capital, accountants use the formula below:  

Net working capital = (current assets) – (accounts payable) – (expenses)  

Importance of Net Working Capital:  

1. Covering Short-Term Liabilities:

Net working capital is the financial cushion that allows businesses to meet their short-term financial obligations. Think of it as the money set aside to pay your monthly rent, salaries, and utility bills. With enough net working capital, a company might be able to keep its operations afloat and avoid running into financial trouble.  

2. Fueling Growth and Investment:

In addition to handling day-to-day expenses, net working capital provides the financial resources needed to seize growth opportunities. Just as individuals save money to make investments, businesses use their net working capital to invest in projects expected to generate more revenue. This could include expanding product lines, entering new markets, or upgrading equipment.  

3. Demonstrating Financial Health:

Net working capital is a vital indicator of a company’s financial health. It’s similar to a report card for a business’s financial condition, conveying its ability to manage liquidity and meet obligations. Banks, investors, and suppliers often scrutinize a company’s net working capital as part of their risk assessment before providing loans, extending credit, or forming partnerships. A healthy net working capital position suggests that a company is well-prepared to navigate economic challenges and withstand financial shocks.  

4. Efficient Resource Utilization:

A high net working capital demonstrates that a company efficiently utilizes its resources. It’s akin to being a prudent spender who optimizes every dollar. This efficiency helps a business maximize its profitability, as it is well-prepared to handle unexpected expenses or invest in income-generating opportunities without relying heavily on external financing.  

5. Facilitating Future Planning:

Net working capital is crucial to a company’s ability to make any plans. It is a financial cushion that allows businesses to weather economic downturns, invest in research and development, and seize new opportunities. In essence, it’s like a savings account that businesses can tap into to ensure long-term growth and adaptability in a dynamic market.  

How to calculate change in net working capital:

1. Add Up Current Assets

You’ll need to tally up all your current assets to calculate net working capital. These items can be quickly converted into cash or used up within the next year. They typically include cash in the bank, raw materials and inventory ready for sale, short-term investments, and account receivables (the money customers owe you). For example, if you have $1.35 million in cash, $750,000 worth of products, $58,000 in short-term investments, and $560,000 in accounts receivable, your total current assets would be $2.158 million. 

2. Subtract Current Liabilities

Next, you subtract the money you owe to others. This includes bills and obligations you still need to pay, such as what you owe to your suppliers, lenders, or service providers. Continuing with the example, if you owe $678,000, you will subtract this amount from your $2.158 million, leaving you with $1.48 million.

3. Deduct Expenses

Finally, you subtract any other financial obligations considered liabilities, such as employee wages, interest payments, and short-term loans that will come due within the next year. In our example, if these expenses amount to $1.075 million, subtract this from the $1.48 million, resulting in a net working capital of $405,000.  

4. Interpret the Results

The final net working capital figure, in this case, $405,000, provides valuable insights into your business’s financial condition. A positive net working capital indicates that your business is in good financial shape and can invest in growth and expansion. If it’s zero, your business can meet its current obligations but may need more investment capacity. A negative net working capital implies that your business needs additional funds to cover its expenses and financial commitments, often necessitating taking loans or seeking new investors to bolster liquidity and overall financial health. 

What is the Net Working Capital Ratio?  

The Net Working Capital Ratio is like a measuring tape for a business’s short-term money compared to everything it owns. It’s like figuring out what part of your allowance you have saved. 

To calculate this ratio, you take a business’s short-term money and compare it to all the money it has. This ratio is expressed as a percentage, which tells you how much short-term money exists in relation to the business’s total money.  

For example, let’s say a company’s short-term bills are $1.89 million, the money it has for the near future is $2.45 million, and the total money it owns is $3.55 million. You can figure out the Net Working Capital Ratio like this:  

Net Working Capital Ratio = (short-term money – short-term bills and expenses) ÷ (total money)  

($2,450,000 – $1,890,000) ÷ ($3,550,000) = $560,000 ÷ $3,550,000 = 0.16 = 16%   

This 16% shows that the company is increasing its Net Working Capital Ratio, which means it’s putting more of its money into things that can be quickly turned into cash. This is a good sign for the company because it is trying to keep its money accessible and ready for use.  

Let’s sum it up!  

Net working capital is a crucial financial metric that directly impacts a company’s ability to meet short-term obligations, invest in growth, efficiently utilize resources, exhibit financial health, and plan for the future. Understanding how to calculate and interpret net working capital is fundamental for effective financial management and decision-making within a business.  

Also Read: Beyond The Formula: Exploring The Nuances Of Net Working Capital

Wajiha Danish

Wajiha is a Brampton-based CPA, CGA, and Controller with 17+ years of experience in the financial services industry. She holds a Bachelor of Science Degree in Applied Accounting from Oxford Brookes University and is a Chartered Certified Accountant. Wajiha spearheads Monily as its Director and is a leader who excels in helping teams achieve excellence. She talks about business financial health, innovative accounting, and all things finances.