As a business owner, you need to gauge the financial health of your business. Ideally, you want to have more earnings than debts and enough funds to cover your current operations.
Unfortunately, there’s no single measurement or ratio that captures the comprehensive health of your business.
Still, there are certain standard calculations that give you insights into your financial status — similar to blood pressure for your body. In particular, net working capital is one of the most common calculations you can use to determine the short-term health of your business.
So, what is net working capital?
Defining Net Working Capital
Net working capital measures the difference between your current assets and your current liabilities. It gives you a good idea of your company’s liquidity and ability to use your current assets to pay for short-term obligations or operating costs.
Current assets include assets you expect to convert to cash or use within a one-year term. They usually include cash, cash equivalents, inventory, supplies, prepaid expenses, and accounts receivable. You may also hear the term working capital to refer to total current assets.
In contrast, your long-term (or fixed) assets include items such as property and equipment, which you do not use up within one year.
Like your company’s current assets, your current liabilities include payments and debts you intend to address within one year. Current liabilities include the current portion of long-term debt and expenses such as your payroll and accounts payable.
Although you get net working capital from assets and liabilities, it is neither an asset nor a liability. It’s a calculation you can use to get a sense of your company’s short-term financial strength.
How To Calculate Net Working Capital
The standard net working capital formula is:
Net Working Capital (NWC) = Current Assets - Current Liabilities
You can find your liabilities and assets on your balance sheet.
To calculate net working capital, you use current (short-term) assets and liabilities instead of long-term.
Net Working Capital Example
To further understand how to calculate net working capital for a business, look at the following example.
Let’s say you own a construction company called NextStep Construction, and you have the following short-term assets and liabilities.
- Cash: $10,000
- Accounts receivable: $6,000
- Stock (raw materials): $4,000
- Accounts payable: $4,000
- Accrued expenses: $1,000
First, calculate your total current assets and liabilities.
Total Current Assets = Cash + Accounts Receivable + Stock
Total Current Assets = $10,000 + $6,000 + $4,000
Total Current Assets = $20,000
Total Current Liabilities = Accounts Payable + Accrued Expenses
Total Current Liabilities = $4,000 + $1,000
Total Current Liabilities = $5,000
Then, subtract your total current liabilities from your total current assets to get your net working capital.
Net Working Capital = Total Current Assets - Total Current Liabilities
Net Working Capital = $20,000 - $5,000
Net Working Capital = $15,000
You have a net working capital of $15,000. Is it good?
How do you interpret net working capital?
Interpreting Net Working Capital
Net working capital tells you about your business’s short-term liquidity. To get the most information from it, you need to look at two factors.
First, is it positive or negative? And second, how does it compare with current liabilities?
Positive Net Working Capital
A positive net working capital — or value greater than zero — tells you that you have enough assets to take care of your current operations. It signals strong short-term financial health.
A higher positive net working capital value means that you can invest in growth without taking on extra liabilities, such as loans.
However, if your net working capital is too high, it suggests that you are inefficient with your assets usage. For example, if much of your working capital comes from low inventory turnover, that’s a sign of inefficiency. You might be overstocking products or experiencing inefficiencies in marketing that prevent you from selling.
So what’s a good net working capital? Ideally, you want a positive net working capital that’s anywhere from 20 to 100 percent of your total current liabilities.
Negative Net Working Capital
A negative net working capital – or value less than zero — means that your business isn’t making enough money to pay for short-term debt. However, a negative net working capital can be good in some cases. It could mean you are effectively borrowing from others to fund your business or that you even repaid a ton of debt that year.
However, if your net working capital remains negative for an extended period of time, you may have to sell your long-term assets to pay for short-term liabilities like employees’ salaries. A consistent trend of negative working capital can signal a risk of bankruptcy and may make it challenging to invest in new growth without incurring more debt or finding additional investors.
Zero Net Working Capital
In some cases, your current liabilities and current assets may cancel one another out. While this can signal financial strength, it’s better to have some net working capital available so you can pay current obligations on time.
How To Improve Net Working Capital
Large corporations can survive with a negative net working capital because they have more bargaining power with their creditors, helping them raise cash quickly.
If you’re a small business owner, you want to have a positive net working capital and feel assured that you can pay your employees and vendors without adding to your debt.
There are two ways to improve your net working capital. You can either increase your total current assets or reduce your total current liabilities:
Increasing total current assets:
- Bill customers immediately after you complete a service or deliver a product
- Incentivize early invoice payment
- Penalize late invoice payment
- Sell unproductive assets
Decreasing total current liabilities:
- Review all vendors and look for savings
- Don’t purchase more inventory before using up current stock
- Reduce fixed expenses
- Refinance debt
- Automate or outsource certain jobs
When to Use Net Working Capital Calculation
You should use net working capital when you want to understand your company’s short-term financial strength. It’s a simple calculation that can tell you about your company’s ability to pay your current bills, such as vendor invoices and employee salaries.
For assessing your company’s long-term health, you still need to look at all of your financial statements and other metrics, such as the debt-to-equity ratio, which includes fixed assets and long-term debt.
Net Working Capital and Your Business
In most cases, you want to aim for a positive net working capital for your business. A positive net working capital means that you can meet your short-term business needs without looking for new investors or applying for loans.
However, net working capital by itself doesn’t give you the big picture about your business.
The good news is that net working capital is a simple metric to calculate, and it’s pretty valuable when used with other indicators. In particular, when paired with working capital (which represents total current assets without subtracting current liabilities), cash flow, and current ratio (net working capital ratio), you can get a better picture of your business’s short-term health.
Finally, calculating net working capital once won’t do you much good. You need to monitor your net working capital over time, so you can keep your business healthy and strong.