“Capital is that part of wealth which is devoted to obtaining further wealth.” – Alfred Marshall
What is net working capital?
Measures a business’s ability to pay its current liabilities (due within one year) using current assets without obtain external funding. It is also a measure of short-term financial health.
How is net working capital calculated?
Net working capital = current assets – current liabilities. Current assets include cash, accounts receivable, inventory, and other assets that are expected to be converted to cash within twelve months; current liabilities included accounts payable, accrued wages, taxes payable or any other liabilities that are expected to come due within twelve months.
What does net working capital mean to my business?
Generally, the more net working capital a business has the better its financial position. A business with strong working capital position is posed to invest, expand or simply be prepared for difficult times. A business with negative working capital is potentially in trouble as it may not have the funds needed to satisfy its short-term obligations.
Savvy business owners understand that managing net working capital is critical to long-term success. Tactics used to manage networking capital can include reduced terms for clients, extending time to pay vendors, and more aggressive collection efforts on outstanding accounts receivable. These tactics should be used with caution as they could upset vendors and customers. One last tactics includes reducing costs. The impact this tactic has is increasing cash since funds were not spent and decreasing payable since a new cost was not incurred, resulting in an overall increase in net working capital.
Negatives to net working capital:
If accounts receivable and inventory are not being converted to cash efficiently, a business could have a deceptively high net working capital balance, falsely indicating a stronger financial position. The calculation for net working capital excludes unused sources of funding such as a line of credit or potential cash infusion from the business owner.