The formula for net working capital (NWC) calculates the amount of money that is left after a company pays its short-term liabilities with its current assets
In other words, it is a difference between a company’s current assets and its current liabilities. It’s used to find out if a company has enough money to pay its short-term debt with its current assets.
Net working capital, sometimes referred to as simply “working capital”, is one of the measures of a company’s financial health, which shows how effectively a company delivers its goods and services to its customers providing a high quality of goods and services in the cheapest way possible.
How to calculate net working capital?
It’s relatively simple to calculate the net working capital. NWC is calculated by subtracting current liabilities from current assets.
NWC = Current \;assets - Current\;liabilitiesNet working capital explained
Net working capital is important because it gives you an idea of how many short-term assets you have to pay your short-term debts and how much money is left to invest to create some income. NWC is great in terms of measuring the effectiveness of your business in the short term.
- NWC > 0. A positive net working capital means that a company is able to pay its short-term debt and invest in its future growth.
- NWC = 0. A zero net working capital means that a company is only able to pay its short term debt and can’t invest in other activities.
- NWC < 0. A negative net working capital means that a company won’t be able to pay its current debts and will have to borrow more money. Otherwise, there’s a risk of insolvency.
What are current assets and current liabilities?
Current assets are the assets which can be transformed into cash within one year. Current assets include:
- Cash
- Cash equivalents – treasury bills, commercial papers, money market funds and short-term government bonds
- Marketable securities – financial instruments, such as stocks, certificates of deposit or bonds with a maturity date of 1 year or less, that are easily sold or bought on public exchanges
- Short-term investments
- Accounts receivable – money owed to the company by customers that should be paid within a year
- Prepaid expenses
- Inventory – materials, goods, products, packaging, etc.
Current liabilities are a company’s debts that must be paid within a year. Current liabilities include:
- Short-term debt
- Current portion of long-term debt – a portion of a long-term debt that has to be paid within a year
- Accounts payable – money for purchasing goods or services by the company that should be paid within a year
- Accrued liabilities – taxes or interest payable
Current and Long-Term assets and liabilities are separated on the balance sheet. That allows to easily calculate financial ratios including liquidity ratios (like net working capital). On the balance sheet accounts are presented in the order of liquidity, so short-term accounts are always presented before long-term accounts.
Net working capital ratio
For example, net working capital ratio of 2 means a company has $2 of current assets for each $1 of short-term liabilities. Optimal net working capital ratio depends on the industry a company operates in, but it’s assumed that NWC ratio should be 1.2-2. If the ratio is less than 1, a company may have problems paying its short-term liabilities. If the ratio is too high, a company keeps too much money in current assets instead of investing it and generating profit.
Examples of net working capital calculations
Example 1: What is ABC company’s net working capital?
ABC COMPANY BALANCE SHEET | |||
Current Assets | Current Liabilities | ||
Cash | $50,000 | Accounts Payable | $40,000 |
Cash Equivalents | $20,000 | Accrued Expenses | $30,000 |
Common Stocks | $5,000 | Short-Term Debt | $30,000 |
Accounts Receivable | $40,000 | Current Portion of Long-Term Debt | $25,000 |
Inventory | $50,000 | ||
TOTAL | $165,000 | TOTAL | $125,000 |
Example 2: What is ABC company’s net working capital ratio?
NWC\;ratio = \frac{\$165,000}{\$125,000} = 1.2The