Net Working Capital: Managing Your Business’s Financial Health
Managing your business’s financial health is very important. Whether you want to grow your business, or simply ensure it’s successful to pass on to the next generation, understanding net working capital is very important to the survival of your business. Here’s what you need to know.
What is Net Working Capital?
Net working capital is a figure that demonstrates that a company has the ability to cover its current liabilities with its current assets. In mathematical form, the net working capital formula is Current Assets – Current Liabilities = Working Capital. If the result of your calculations is negative, your business is said to have negative working capital.
If you don’t remember what the difference is between a long-term asset and a current asset, here’s a quick refresher. Current assets are assets that you expect to convert to cash within a year. You would include assets like cash, investments you can liquidate quickly, prepaid expenses, accounts receivable and inventory. Current liabilities are liabilities you have to pay within a year. Things like the next year’s worth of payments on a long term business loan, accounts payable, other short-term payables and accrued expenses should be included in current liabilities.
Another way to look at working capital is through the working capital ratio. The mathematical formula is Current Assets / Current Liabilities = Working Capital Ratio. A result of 1.0 or greater means you have enough current assets to pay off all of your current liabilities today. It also means you have positive working capital. A result of less than 1.0 means you would not be able to pay off your current liabilities using only your current assets. Your business would be classified as having negative working capital.
Determining the Health of Your Business with Net Working Capital
The working capital formula and working capital ratio are two easy ways to take a quick glance at your business’s health. If the working capital formula results in a negative number, or the ratio’s result is less than 1.0, you have negative working capital. Typically, if either of these cases are true, you may end up having trouble paying your bills sometime within the next year. Your business may have plenty of long-term assets and no long-term liabilities. However, if you can’t pay the bills that are due today, you may find yourself making less than optimal business decisions to make sure you can keep the lights on at your business as a result of not being able to pay today’s bills.
On the other hand, if the working capital formula results in a positive number, or the ratio’s result is greater than 1.0, you have positive working capital. Your business should be able to continue operating without any major cash flow problems within the next year. That said, the working capital formula and ratio only assesses the near term. They do not tell you anything about how well your business will do financially beyond the next 12 months.
Examples on How to Calculate Net Working Capital
Example 1: Business A has $10,000 in cash, $12,000 in accounts receivable and $5,000 in prepaid expenses. They have $9,000 in accounts payable and $5,000 of short-term debt payments due within the next 12 months.
|Working Capital||$27,000 – $14,000 = $13,000|
|Working Capital Ratio||$27,000 / $14,000 = 1.93|
Business A has positive working capital and a healthy ratio.
Example 2: Business B has $5,000 in cash, $3,000 in accounts receivable and $2,000 in prepaid expenses. They have $12,000 in accounts payable and $4,000 in other payables.
|Working Capital||$10,000 – $16,000 = -$6,000|
|Working Capital Ratio||$10,000 / $16,000 = 0.63|
Business B has negative working capital and an unhealthy ratio.
In the first example, Business A has net working capital. This is a healthy sign that the company is able to cover its current liabilities with its assets. However, if Business A’s assets start to increase while its liabilities continue to decrease, this will demonstrate that management isn’t effectively managing their working capital. This is why the working capital ratio is so important to calculate. If the ratio is anywhere over 2, it can be a sign of a deficiency in working capital management.
Stay Positive with Working Capital Management
You have the knowledge necessary to manage your working capital now that you understand how to calculate the results of the working capital formula and ratio. The easiest way to monitor your working capital is using a balance sheet. This document should list your assets, liabilities, and equity of the business. Most balance sheets break down assets and liabilities into current and long-term assets and liabilities with subtotals. If yours doesn’t, ask your accounting department to add the classifications and subtotals to make working capital management easier.
Keeping your net working capital in good shape will help you prepare for any unexpected opportunities that may arise in the course of your day to day business operations. If you have positive working capital, you may be able to use your current assets to devote funds to certain areas of the business without having to go to a lender or investor to raise additional money. Even if you do need to go to a lender or investor, having positive working capital will show necessary parties your business is on sound financial footing for the next twelve months.
If you aren’t happy with your business’s current working capital position, you have a couple options. You can work over time to improve your financial position slowly. On the other hand, you can take out a working capital loan to address your needs in a faster manner.
Supplementing Your Business with Working Capital Loans
Financing your working capital can help you improve your current capital position. These loans give your business an infusion of cash. Working capital loans can help your short-term cash position while giving you the ability to repay short-term liabilities. Working capital loans allow your business the time it may need to turn your longer term or illiquid assets into current assets. You’ll be able to do this without selling them at greatly discounted prices. Without working capital loans, a business with negative working capital may not be able continue funding day-to-day operations. At least not without having to go through bankruptcy. Of course, you’ll need to make sure your business will be generating additional net working capital in the near future from other methods. Without a long-term solution to your working capital needs, your business may eventually face bankruptcy anyway.