What Is Net Working Capital? With Definitions and Formulas for Small Business
Net working capital is the difference between a business’s current assets and its current liabilities. Net working capital is calculated using line items from a business’s balance sheet. Generally, the larger your net working capital balance is, the more likely it is that your company can cover its current obligations.
These topics cover what net working capital is and why it’s important for small business accounting:
What Is Included in Net Working Capital?
Net working capital gives a good indication of the financial health of a small business. Net working capital shows the liquidity of a company by subtracting its current liabilities from its current assets. These are the line items from the balance sheet included in the net working capital calculation:
- Current Assets: Current assets are all assets that will be converted to cash within a year, including currency, accounts receivable, inventory and prepaid expenses.
- Current Liabilities: Current liabilities are all short-term debts that will be paid within a year, including rent, utilities, payroll and payments toward long-term debt.
How to Calculate Net Working Capital
Calculating net working capital helps a business understand how well it’s able to cover its obligations in the short term. To calculate net working capital, follow these steps:
1. Add Up Current Assets
First, add up all the current assets line items from the balance sheet, including cash and cash equivalents, marketable investments and accounts receivable.
2. Add Up Current Liabilities
Next, add up all the current liabilities line items reported on the balance sheet, including accounts payable, sales tax payable, interest payable and payroll.
3. Calculate Net Working Capital
Subtract your current liabilities from your current assets. The final figure gives your business’s net working capital.
Net Working Capital Formula
The formula for calculating net working capital is:
Net Working Capital = Current Assets – Current Liabilities
Why is Net Working Capital Important?
Net working capital is important because it gives an idea of a business’s liquidity and whether the company has enough money to cover its short-term obligations. If the net working capital figure is zero or greater, the business is able to cover its current obligations. Generally, the larger the net working capital figure is, the better prepared the business is to cover its short-term obligations. Businesses should at all times have access to enough capital to cover all their bills for a year.
Net working capital is most helpful when it’s used to compare how the figure changes over time, so you can establish a trend in your business’s liquidity and see if it’s improving or declining. If your business’s net working capital is substantially positive, that’s a good sign you can meet your financial obligations in the future. If it’s substantially negative, that suggests your business can’t make its upcoming payments and might be in danger of bankruptcy.
Net working capital can also give an indication of how quickly a company can grow. If a business has significant capital reserves it may be able to scale its operations quite quickly, by investing in better equipment, for example.
How to Improve Net Working Capital
Small businesses can make certain changes to their operations if they want to improve their net working capital. Some of those adjustments include:
- Change your payment terms to shorten your billing cycle and ensure your customers pay you more frequently for your goods or services
- Be diligent about following up with clients as soon as an invoice is due, so you can collect late payment more quickly
- Return unused inventory to your vendors so that you can receive a refund for the cost
- Lengthen the payment period for your vendors, if they’ll allow it without charging late fees