Net Working Capital
Net working capital is less a liquidity ratio than a simple liquidity measure. Instead of division, net working capital assesses a company’s capacity to pay its current obligations by subtracting current obligations from current assets.
Net Working Capital Formula:
Net working capital = Current assets - Current obligations
Current assets: These are a company’s assets that are expected to be used or sold within one calendar year. Current assets can include cash, cash equivalents, accounts receivable, inventory, and prepaid liabilities, among other liquid assets.
Current obligations: Also called current liabilities, these are a company’s short-term financial obligations, due within one calendar year. Current liabilities can include accounts payable, short-term debt, dividends, and taxes owed, among other financial obligations.
What can Net Working Capital tell me about my business?
Because net working capital works on simple subtraction, it’s pretty easy to wrap your head around. A positive number means you have more assets than liabilities projected for the next year, meaning you should be able to pay off your upcoming obligations. A higher number is usually better, as that indicates a greater financial cushion.
Be aware that you can also have negative net working capital, meaning the amount you are expected to owe in the next year is greater than the amount of assets you are expected to have. This is a problem, and likely will require immediate adjustments to your business model and financial strategy. If negative net working capital is not addressed, a company may have trouble repaying loans, or even go bankrupt.
If net working capital is extremely high, that’s not always a good thing either. It may indicate that a company is keeping too much inventory, or not being smart about reinvesting cash reserves into expansion, or having difficulty collecting on customer accounts receivable.
Net working capital should also be tracked over a period of time, in order to keep an eye on the trajectory of your business’s financial health. Trends are ultimately much more indicative of successful or struggling businesses than a single number.
Net working capital is a vital indicator of solvency, and should be rigorously tracked.