The How-To Guide to Working Capital
Learn more about net working capital, associated terms, and how to calculate it (plus more).
If you’re looking to grow your business, you need to know your net working capital and how it affects your business’s potential.
If you’d like to check in on your business’s ability to grow and invest, calculating your net working capital is a great place to start.
This number is the most accurate way to prove your company’s liquidity.
Here’s an overview of what you can expect to take away from reading this article:
- Definitions of common terms related to net working capital
- A simplified formula for calculating yours
- Tips on increasing your business’s net working capital
- Some things to avoid when working toward increasing your net working capital
Glossary of Terms
Here’s a short list of definitions to ensure you understand all terms included in this article:
Asset-to-Liability Ratio
Also known as a total debt-to-asset ratio, it is used to measure your company’s debt in relation to its assets.
By comparing a company’s asset-to-liability ratio to that of its competitors, analysts can determine which company is more financially stable within an industry.
Current Assets
Current assets are any assets that a business can reasonably expect to sell or use to cover operating costs for the year or the current operation cycle.
Current Liabilities
Current liabilities are any short-term obligations that will impact a business’s finances in the current year or operating cycle.
Degree of Operating Leverage
Degree of operating leverage is a metric used by analysts to determine how much a change in sales impacts a company’s liquid income. This metric is used mainly to assess if the company is an investment risk.
Long-Term Liabilities
Long-term liabilities are any debts that are not expected to be paid off within the current year or operating period. These might include long-term loans, deferred taxes, or capital leases.
Short-Term Obligations
Short-term obligations are any debts due within the current year or operating period.
Short-Term Liquidity
Short-term liquidity refers to a company’s ability to cover any short-term obligations with short-term assets.
How to Find Net Working Capital [Simple Formula]
Here’s the simplest net working capital formula:
(Current Assets) – (Current Liabilities) = (NWC)
That’s it. Total your current assets and current liabilities, then subtract the total of your liabilities from the total of your assets.
The resulting number is your business’s net working capital.
As simple as this formula is, you can make things even easier by using this free net working capital template from the Corporate Finance Institute.
Here’s an Example of How to Calculate Net Working Capital
Company A is trying to determine its net working capital.
They look at their balance sheet and determine that they have total current assets of $85,000.
They then calculate their current liabilities to equal $45,000.
The formula they would use to determine their net working capital will look like this:
$85,000-$45,000= $40,000
How to Calculate Your Assets and Liabilities
All of the information you need to find your business’s current assets and liabilities can be found on your financial statements.
We’ll explain a little bit more about calculating each of them below.
How to Calculate Current Assets
Calculating your current assets is fairly straightforward.
You simply need to locate on your balance sheet any asset that can be converted into active income for your business during the current year or operating period.
This only includes short-term assets, such as:
- Cash or cash equivalents
- Accounts receivable
- Marketable securities
- Inventory that can be sold and used to fund your operating costs
Your current assets do not include long-term assets like furniture, equipment, buildings, or company land.
How to Calculate Current Liabilities
To calculate your current liabilities, locate all bills on your balance sheet due in the current year or operating period.
Anything due beyond the current year or operating period should not be included in this calculation.
You should count your company’s:
- Accounts payable
- Notes payable
- Sales and income taxes
- Rent
- Employee wages
- Utilities
- Workman’s compensation payments
- Credit card payment
- Any accrued expenses
Please note: While they may seem like long-term debts, mortgage and other loan payments are current liabilities. Although the entire loan may not be due in the next year or operating period, the principal you owe on that loan within that time frame is a current liability.
Limitations of the Concept of Net Working Capital
As with any business metric, net working capital is not a perfect measurement of your company’s value. There are always factors that are out of your control.
For instance, although you can try your best to speed up invoice payments, you cannot control when or if a client will pay you. And there is always the possibility of unforeseen circumstances. Even your best efforts to reduce your overhead may fail.
Some of your other assets may not be able to be converted into cash as quickly as anticipated, like your inventory. Try as you may, you may not be able to sell them or get a refund on them.
Due to these many uncontrollable factors, it’s hard to estimate the liquidity of your current assets.
This is why it’s essential to proactively manage your business accounts and reduce your liabilities before they begin clogging your cash flow and threatening your company’s financial health.
Be careful about how you attempt to increase your net working capital, too. Certain strategies can cause you to overspend on things you don’t really need.
For example, refinancing a short-term loan into a long-term loan will result in paying more interest.
Related: How Does a Working Capital Loan Work?
What Is Your Current Net Working Capital Ratio?
Once you calculate your net working capital, you can calculate another important business metric:
Your current net working capital ratio, also known as your current asset-to-liability ratio.
This measurement describes a company’s ability to meet its financial obligations. Business analysts see this ratio as a reflection of how well a company is being managed and how much operating leverage it has in its industry.
How to Calculate Your Asset-to-Liability Ratio
Instead of subtracting liabilities from assets (as you would to find working capital), you divide the total current assets by the total current liabilities.
If the ratio is over 1:1, you know you can cover your liabilities.
If the ratio is 2:1 or more, you could benefit from using your assets more efficiently. This is called a positive net working capital ratio. The amount of net working capital you have can be used for company growth.
If the ratio is lower than 1:1, you won’t be able to cover your liabilities, and you need to find a way to increase your working capital. This scenario is called negative net working capital.
The optimal asset-to-liabilities ratio to strive for is about 1.5:1 times. This number proves that your short-term liquidity is healthy.
The example that we used above (click here to revisit) shows that Company A’s current net working capital ratio is $85,000/$45,000. This is a healthy ratio of 1.89:1.
How to Increase Your Net Working Capital
If you find that your business has negative net working capital, you need to do something to rectify that.
There are two ways to increase your net working capital:
Increase your current assets or decrease your current liabilities.
Of course, it’s best to do both. Increasing your assets while decreasing your liabilities will give you even more capital to work with.
Below we’ll show you five ways to do each (for a total of ten strategies you can use).
5 Ways to Increase Your Current Assets
Here are a few strategies you can use to increase your company’s current assets:
1. Actively Pursue Any Unpaid Invoices
This may require you to hire an invoice collection service. It can be a frustrating endeavor for someone who is already bogged down with other tasks.
Consider using an accelerated invoicing system. This can take the load off any individual in the company and streamline the process.
2. Purchase Inventory Only When You Need It
It may be tempting to buy in bulk to save money, but anything sitting in your warehouse is only costing you money. Resist the urge to overspend on sale-priced inventory.
You can waste a lot of money trying to save money.
Related: What Is an Inventory Loan (and Should You Get One)?
3. Return Overstocked Inventory to Suppliers for Refunds
If you notice that you’ve overstocked on any raw materials and don’t see yourself using them in the near future, ask the supplier if they will accept returns for a refund.
Some suppliers will gladly do this; others won’t. Some may accept your items, but for a small restocking fee.
4. Sell Off Any Inessential Long-Term Assets
You might have some assets that aren’t necessary to your operation, especially if you purchased your company as a turnkey business.
Selling these long-term assets, such as equipment or real estate that are inessential to your business, can be an easy way to increase your working capital.
You can also sell essential long-term assets to a finance company and lease them back.
This will turn a long-term asset into a short-term asset to meet your business needs. It will raise your current liabilities, but the current portion due will be much less than the liquid assets gained.
5. Raise Your Pricing
If your current assets don’t cover your current liabilities, you can be sure they won’t in the future if you don’t find a way to increase your working capital.
The simplest way to increase your inflow of money is to increase your prices.
5 Ways to Decrease Short-Term Liabilities
Here are a few strategies you can use to limit your expenses:
1. Refinance Short-Term Debt With Long-Term Loans
One option is to extend the lifespan of your loans.
You’re likely to pay more in interest over time, but your liabilities will be smaller from month to month.
2. Consolidate Interest-Bearing Debt
Do you have several loans that you pay each month?
You may be able to reduce your total monthly payments (as well as your interest accrued) by consolidating these loans.
Again, refinancing and debt consolidation can have a negative financial impact in the long term, as they can result in higher interest over time. If you choose to use these means, make sure to research the payment terms before you decide.
3. Evaluate and Eliminate Unnecessary Overhead
Every small business can find ways to cut back on unnecessary spending. It may just require a fresh pair of eyes or a different production strategy.
If you can’t make ends meet the way you’ve been running your business, you have no choice but to cut back somewhere.
4. Sell Inventory to Reduce Maintenance Costs
If refunds aren’t available on your overstock, consider selling any slow-moving items that require more resources to maintain than they are worth.
5. Defer Tax Liabilities
With the help of a tax specialist, you may be able to reduce your tax liabilities enough to increase your current ratio and keep your business in production.
As this article shows, working capital management is much simpler than it sounds. The terms used may sound complex, but in truth, they are easier to comprehend than expected.
Its simplicity does not negate its importance, however. Your company’s working capital is the very reason you are still in business today.
Without positive net working capital, even a profitable business could find itself in bankruptcy. Smart business owners know how to maintain a balance of current assets to liabilities and keep things afloat.
Keep your working capital out of the red with Now’s accelerated invoice payment solutions!
