Net Working Capital Formula: What Is It, and Why Does It Matter?
18 November 2022 |
The C2FO Team
The net working capital formula is an important financial equation to understand. It can tell you if you have the funds to meet your current obligations or invest in growth, or when you need to improve cash flow.
Net working capital is one of the most helpful measures of a company’s success. To maintain day-to-day operations, you need to be able to cover your short-term obligations, such as rent, utilities and payroll. To grow your business, you need to be able to invest in revenue-generating opportunities. Both require you to have a healthy cash flow and liquid assets, or working capital.
If you’d like to evaluate your company’s financial health and ability to grow, you need to know your net working capital and understand what it means for your business. However, you may have a few questions: What is net working capital? How do I calculate it? Why does it matter for my business? How can I optimise it and increase my reserve? In this post, we’ll help you answer these questions and more.
What is net working capital?
Net working capital is sometimes shortened to working capital, but both mean the same thing. This term refers to the difference between your current assets (for example, cash flow, invoices and inventory) and current liabilities (such as accounts payable) on your balance sheet. To be considered current or short-term, these liabilities and assets must be expected to be paid or accessed within a year, or one business cycle, whichever is less.
What is the net working capital formula?
To calculate your business’s net working capital, you need to subtract your total current liabilities from your total current assets. The formula is:
LET’S TAKE A CLOSER LOOK:
1. Total your current assets
First, add all the line items that are current assets on your balance sheet. Include cash and cash equivalents, investments and accounts receivable.
2. Total your current liabilities
Next, add all the line items that are current liabilities on your balance sheet. Include accounts payable, taxes owed, interest and payroll.
3. Calculate net working capital
Finally, subtract your current assets from your current liabilities. The resulting figure is your business’s net working capital.
NET WORKING CAPITAL FORMULA EXAMPLE
For example, consider the following sample list of a company’s current assets and liabilities.
Accounts Receivable: £30,000
Total Assets: £120,000
Accounts Payable: £15,000
Accrued Expenses: £10,000
Other Trade Debt: £25,000
Total Liabilities: £50,000
By subtracting the company’s total current liabilities (£50,000) from its total current assets (£120,000), it is evident that its current assets exceed its current liabilities, yielding a positive net working capital of £70,000.
Why does net working capital matter?
Net working capital is an important financial metric to track because it indicates your company’s liquidity and whether you have the capital to cover your costs in the short term and to invest in growth opportunities. Further to that, suppliers, investors and other creditors will typically have an interest in metrics like your free cash flow and your net working capital because they provide a snapshot of your company’s financial status, and your ability to use assets efficiently and pay off current liabilities.
If your net working capital figure is zero or greater, your business should be able to meet current obligations. Generally, the larger your net working capital, the better position your business is in to cover your short-term obligations.
For example, a positive net working capital (greater than zero) typically indicates that your company has the ability to invest in future growth. In contrast, with a net working capital of zero, you’ll only be able to meet current financial obligations. Further, if your net working capital figure is negative, you’ll need to find ways to increase your working capital or apply for financing to cover your short-term costs. Finally, a positive net working capital figure isn’t always a great thing either, because it could indicate that your money is sitting idle instead of being invested in company growth or that you have an overstock of inventory.
How to increase net working capital
Whether you are in a season of high demand and your net working capital is lower than usual, and you need ways to improve it quickly, or it is positive and you want to increase your reserve to invest in future growth, there are several tactics you can leverage. Here are a few that can help you free up cash and optimise your working capital:
OPTIMISE ACCOUNTS RECEIVABLE PROCESSES
The best way to ensure you have working capital is to keep money coming in on time or early. In other words, you want to shorten your cash conversion cycle and reduce your days sales outstanding. Make sure you send out invoices as soon as possible (unpaid invoices increase your current assets). Consider automating accounts receivable processes to improve overall efficiency.
INCENTIVISE EARLY PAYMENT WITH DYNAMIC DISCOUNTING
A debt-free way to increase cash flow and improve your working capital is to offer incentives to customers that pay their invoices early. You can accelerate payments using dynamic discounting, a flexible early payment solution that lets you select invoices for early payments and set discount rates.
IMPROVE INVENTORY MANAGEMENT
Inventory is a current asset, so it’s included in the net working capital formula. If your inventory is slow-moving or inefficiently managed, it can extend the days inventory outstanding in your operating cycle, which can significantly impact the net working capital you have available. By optimising inventory processes and turnover you can increase your net working capital.
NEGOTIATE NEW SUPPLIER AGREEMENTS OR CHANGE SUPPLIERS
Review your supplier agreements for potential ways to save. You may be able to negotiate better contractual terms with your suppliers. Failing that, you might look into switching to another supplier for a better price.
SELL OR REIMAGINE THE USAGE OF LONG-TERM ASSETS
If your business has long-term assets like buildings or equipment, analyse them to evaluate usage and determine whether the returns on the investment are worthwhile. If not, consider repurposing your use of them (subleasing space, for example) to save costs or selling unused items. This can increase your cash flow, which is a current asset, so your net working capital will improve.
REFINANCE SHORT-TERM DEBT FOR BETTER RATES
When you refinance short-term debt with long-term debt, you can reduce your current liabilities. Refinancing can stretch out payment schedules and lower monthly payments, providing more cash for working capital.
The bottom line
The success or failure of your business depends heavily on your net working capital. Therefore, it’s critical to understand why working capital matters, and how to calculate and interpret it. Routinely tracking your net working capital can let you know ahead of time when you need to improve or increase your cash reserve. Ultimately, it’s one of the best ways to gain valuable insight into your company’s financial stability, efficiency and ability to invest in future growth.