Net working capital is the difference between a company’s current assets and current liabilities. Positive net working capital indicates that a business can meet its short-term financial obligations and also invest in other activities and future growth. Negative working capital, on the other hand, suggests that a company may find it difficult to grow, pay back creditors, or even avoid bankruptcy.
Read on for a closer look at what net working capital is, how it’s calculated, and what it can tell you about your company’s financial position.
Key Points
• Net working capital measures a company’s liquidity and short-term financial health by comparing current assets to current liabilities.
• Positive net working capital indicates a company can meet its short-term obligations and invest in growth.
• Negative net working capital occurs when current liabilities exceed current assets and suggests liquidity issues.
• Lenders will often look at net working capital to help determine if a business can comfortably afford a loan.
• Industries with longer production cycles typically require more working capital due to slower inventory turnover.
What Is Net Working Capital?
Net working capital (NWC) is a measure of a company’s liquidity and short-term financial health.
NWC looks specifically at the difference between a company’s current assets (cash and assets that can be converted into cash within a year) and its current liabilities (payroll, accounts payable, taxes, and interest owed). It provides a window into how well a company has been managing its affairs, and how well it will be able to meet its short-term obligations, such as unpaid taxes and short-term debt.
Business owners will often calculate and track net working capital in order to monitor trends in liquidity from year to year, or quarter to quarter. Lenders may also look at net working capital when a business is applying for a small business loan to determine if the firm is financially strong enough to take on the debt payments.
Net Working Capital Formula
The basic formula for how to calculate net working capital is straightforward:
Current Assets – Current Liabilities = Net Working Capital
What Is Included in Net Working Capital?
Current Assets
A current asset is anything on a company’s balance sheet that can be converted to cash in less than a year. This can include:
• Accounts receivable
• Cash (or a cash equivalent)
• Commercial paper
• Inventory
• Marketable securities (e.g., U.S. Treasury bills, money market funds)
• Short-term investments a company intends to sell within one year
• Treasury bills
• Short-term notes receivable (e.g., short-term loans to customers or suppliers)
• Prepaid expenses, such as insurance premiums
• Advance payments on future purchases
For example, if company ABC has $100k in cash, $15k in accounts receivable, and $10k in inventory, then that company would have $125k in current assets.
Current Liabilities
A current liability is any financial obligation a company owes that is due within one year. This includes:
• Interest payable on loans
• Any loan principal that must be paid within a year
• Deferred revenue (e.g., advance payments from customers)
• Rent
• Taxes payable
• Utilities
• Trade credits
• Vendor notes
• Wages
• Other accrued expenses payable
For example, if a company ABC has $15k in accounts payable, $2k in accrued liabilities, and a $10k due on a working capital loan this year, then that company would have $27k in current liabilities.
Company ABC’s net working capital would be current assets ($125k) minus current liabilities ($27k), or $98k.
How Does Net Working Capital Work?
A company’s working capital is used to fund operations and meet short-term financial obligations. If a company has sufficient working capital, it means that it will be able to pay its employees and suppliers, pay interest on any loans, pay taxes, and pay other short-term financial obligations, even if it runs into cash flow challenges.
Having positive working capital can also mean that a business can fund growth without incurring debt. Or, if they decide to apply for financing, that positive working capital can make it easier for them to qualify for a small business loan or other form of credit with attractive rates and terms.
How much working capital a company needs will depend on its size and industry. Generally, industries with longer production cycles require more working capital, since turnover of inventory is slower. Companies that make sales daily (like large retailers), on the other hand, can generate funds quickly and tend to need less working capital.
Calculating Net Working Capital
While the formula for calculating net working capital is simple, you may be unsure about how to account for all of your company’s current assets and liabilities.
Fortunately, all the components of working capital can be found in a company’s balance sheet, which is a snapshot of the company’s assets, liabilities, and shareholders’ equity at a moment in time (usually at the end of a quarter or fiscal year).
Assets are listed by category in order of liquidity (the ease with which they can be converted into cash), starting with cash and cash equivalents, followed by long-term assets (which cannot be liquidated in the next year).
Liabilities are listed in the same way, starting with current liabilities (due within one year), followed by long-term liabilities (due at any point after one year).
Uses of Net Working Capital
Net working capital is ultimately a tool that can be used by analysts, business owners, and lenders to determine how well a company is performing. While it doesn’t provide a complete picture, net working capital is a valuable variable in understanding how solvent a company is, and whether or not that company can take on additional debt.
If net working capital is positive, for example, it indicates that the business has short-term funds available from its current assets that are more than sufficient to pay for its current liabilities as they come due for payment.
If, on the other hand, NWC is negative, the business may not have sufficient funds available to pay for its current liabilities, and could, in fact, be at risk for small business bankruptcy.
Recommended: Working Capital Assessment
Net Working Capital vs Working Capital
If you know what working capital is, then you know what net working capital is. The two are generally considered one and the same. Both refer to the difference between all current assets and all current liabilities.
However, some analysts will define net working capital more narrowly than working capital. They might instead use this formula:
NWC = Current Assets (Less Cash) – Current Liabilities (Less Debt)
Pros and Cons of Using Net Working Capital
| Pros of Net Working Capital | Cons of Net Working Capital |
|---|---|
| Quick calculation to determine a company’s health for the short-term | Measured on one day, so may be skewed by a one-time large account payable not yet paid |
| Suggests whether a company can take on additional debt or expenditures | Can be misleading, since a business may have a large line of credit to use for any temporary shortfalls |
| Can be used to reveal changes in operating activities, and whether those changes are with assets or liabilities | Current assets are not necessarily very liquid, and accounts receivable may not be collectible in the short term |
Example of Net Working Capital Calculations
Company XYZ has the following in current assets and current liabilities.
Current Assets:
Cash: $40,000
Inventory: $15,000
Accounts receivable: $10,000
Total: $65,000
Current Liabilities:
Short term debts: $15,000
Accounts payable: $10,000
Accrued liabilities: $5,000
Total: $30,000
Net Working Capital:
Current Assets ($65,000) – Current Liabilities ($30,000) = NWC ($35,000)
NWC = $35,000
Net Working Capital Schedules
A net working capital schedule is a statement of change in the net working capital of a company. It is often created by an analyst using an Excel sheet, and is calculated in accordance with GAAP (generally accepted accounting principles), using the accrual method of accounting.
Accrual accounting is when expenses and sales are recorded at the time of the transaction and not necessarily when the money is received or spent.
A net working capital schedule includes sales and cost of goods sold from the income statement for all relevant periods. It also separates current assets and current liabilities into two sections, and creates a final total for net working capital. It may also create another line to calculate the increase or decrease of net working capital in the current period from the previous period.
The schedule will typically also include historical data, as well as forecast data, so it can be used to track changes in NWC and forecast future NWC.
Recommended: Understanding Working Capital Lines of Credit
Changes in Net Working Capital
Changes in working capital indicate whether a company’s short-term assets are increasing or decreasing in relation to its short-term liabilities. To measure the change, you can use the following formula:
Change in NWC = Beginning NWC – End NWC
It’s generally more useful to compare multiple quarters than it is to compare only the most recent two. This allows you to identify trends. For example, a new business loan will increase a company’s current liabilities, but if it’s “good” debt, the company will be able to use it to its advantage to increase profits. However, it may take more than one or two quarters to see whether the debt was a good decision or not.
Changes in revenue are also to be expected. It can take multiple changes in working capital to determine whether a business is truly on the up and up or going through a downward trajectory.
Net Working Capital Ratio
Net working capital ratio compares a company’s current assets to its short-term liabilities. Like NWC, the NWC ratio can be used to determine whether a firm has sufficient current assets to cover their current liabilities.
To calculate your company’s working capital ratio, you simply divide your current assets by your current liabilities:
Current Assets ÷ Current Liabilities = Net Working Capital Ratio
Example:
A company has $75k in cash, $100k in inventory, and $200k in accounts receivable. It has $200k in accounts payable and $100k due this year on a business loan. Therefore:
$375k ÷ $300k = 1.25
A working capital ratio of less than 1.0 can suggest potential future liquidity problems. An ideal ratio is generally somewhere between 1.5 and 2.
Recommended: Debt Factoring
The Takeaway
Net working capital is the difference between a company’s current assets and its current liabilities. Positive working capital indicates that a company can pay its bills and invest to spur business growth.
As a small business owner, it’s a good idea to calculate and manage your net working capital. This helps ensure that your company can meet its day-to-day operating expenses while using its financial resources in the most productive and efficient way.
Knowing your NWC is also important if you are interested in getting a small business loan. Lenders generally like to see positive NWC because it suggests that a company can take on additional debt and keep up with payments. However, NWC is usually one of many factors a lender looks at when determining loan eligibility.
If you’re seeking financing for your business, SoFi is here to support you. On SoFi’s marketplace, you can shop and compare financing options for your business in minutes.
FAQ
How is net working capital calculated?
To calculate net working capital, you subtract a company’s current liabilities from its current assets:
Net Working Capital = Current Assets – Current Liabilities
What is net working capital on a balance sheet?
Net working capital is calculated using items from a balance sheet (including cash, accounts receivable, inventory, accounts payable, interest payable on loans, and taxes payable). However, it is not an item featured on a balance sheet.
How are working capital and net working capital different?
Net working capital and working capital are typically synonymous. Both refer to the difference between a company’s current assets and current liabilities.
Some analysts, however, define net working capital in a more narrow way than working capital, and will exclude cash from current assets and debt from current liabilities.
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