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\;liabilities

Net 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

Net working capital ratio (NWC) is a ratio that is used to measure the percentage of a company’s short-term assets to its short-term liabilities. This ratio is useful because it allows to compare different companies in the same industry or can be used for one company to compare its NWC in time. This ratio is also called current ratio.

NWC\; ratio = \frac{Current\;assets}{Current\;liabilities}

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?

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
NWC = \$165,000 - \$125,000 = \$40,000

Example 2: What is ABC company’s net working capital ratio?

NWC\;ratio = \frac{\$165,000}{\$125,000} = 1.2

The net working capital ratio (current ratio) is 1.32 which means that this company is able to pay its short-term debt and potentially invest in its future growth – which is a sign of a healthy and sustainable company.