Net working capital shows how well a business can pay its bills in the immediate future. It can also reveal whether a company uses its short-term assets effectively. Business owners only need a balance sheet to calculate this important metric.
Definition of Net Working Capital
Net working capital, often referred to as working capital, equals current assets minus current liabilities. Current assets include any assets a business expects to sell or consume within a year, while current liabilities fall due within a year. Therefore, net working capital shows how much a company's short-term resources exceed amounts due within a year.
A business with low or negative net working capital may struggle to pay its bills over the next year. Failure to raise additional funds could result in severe liquidity issues or even bankruptcy.
Most companies need working capital well above zero because accounts receivable and inventory take time to convert to cash and sometimes prove uncollectable or unsellable. However, this varies by industry. Retailers, restaurants, and other companies that quickly generate cash from accounts receivable and inventory often require less net working capital.
Companies with significant net working capital have more short-term financial security and flexibility. However, excessive net working capital can reveal undesirable inventory accumulation or too much cash—which could earn a better return if invested. The size, industry, and expansion plans of a business all affect the ideal amount of net working capital.
Net working capital differs from the current ratio because it provides a dollar amount rather than a percentage. A business with current assets equal to current liabilities has a net working capital of $0 and a current ratio of one. Small companies could have a high current ratio but not enough working capital to meet any unexpected cash needs. Conversely, large companies with positive working capital but a low current ratio might need additional working capital.
Net Working Capital Formula
Current assets minus current liabilities equals net working capital.
Current assets consist of all assets a company expects to sell or consume within one year. Examples include:
- Accounts receivable
All liabilities due within one year are current liabilities. This includes:
- Accounts payable
- Accrued expenses
- Any portion of long-term debt due within one year
Some businesses—often large ones with separate finance departments—choose to calculate net working capital differently by excluding cash or certain short-term liabilities. Most small businesses do not need to adjust the standard formula.
Net Working Capital Example
The following example illustrates how to calculate net working capital and what it may mean for a business.
ABC Company has cash of $30,000, accounts receivable of $50,000, inventory of $70,000, and long-term fixed assets of $500,000. Current assets equal $150,000 ($30,000 cash plus $50,000 accounts receivable plus $70,000 inventory).
ABC Company owes accounts payable of $50,000, accrued expenses of $90,000, and long-term debt of $200,000, with $40,000 due this year. Current liabilities equal $180,000 ($50,000 accounts payable plus $90,000 accrued expenses plus $40,000 long-term debt due this year).
Net working capital for ABC Company equals ($30,000). That's $150,000 current assets minus $180,000 current liabilities.
ABC Company enjoys $310,000 of equity ($650,000 of total assets minus $340,000 of total liabilities). However, net working capital does not include the long-term fixed assets and long-term debt, except the portion due within one year.
Negative net working capital indicates that ABC Company could face significant difficulty paying its bills over the next year. ABC Company should strongly consider raising additional capital. This could include additional long-term debt or selling some of the company's fixed assets.
Calculating net working capital gives you crucial information about your company's short-term financial health. Managing net working capital effectively will help ensure your business can pay its bills over the next year without hoarding excessive cash or inventory.