Net Working Capital Formula
Working Capital Formula: Net working capital is a liquidity calculation that measures a company’s ability to pay off its current liabilities with current assets. This measurement is important to management, vendors, and general creditors because it shows the firm’s short-term liquidity as well as management’s ability to use its assets efficiently.
Much like the working capital ratio, the net working capital formula focuses on current liabilities like trade debts, accounts payable, and vendor notes that must be repaid in the current year. It only makes sense the vendors and creditors would like to see how much current assets, assets that are expected to be converted into cash in the current year, are available to pay for the liabilities that will become due in the coming 12 months.
If a company can’t meet its current obligations with current assets, it will be forced to use it’s long-term assets, or income-producing assets, to pay off its current obligations. This can lead to decreased operations, sales, and may even be an indicator of more severe organizational and financial problems.
How do you calculate working capital?
Working capital is calculated by using the current ratio, which is current assets divided by current liabilities. A ratio above 1 means current assets exceed liabilities, and generally, the higher the ratio, the better.
What is included in working capital?
Because it includes cash, inventory, accounts receivable, accounts payable, the portion of debt due within one year, and other short-term accounts, a company’s working capital reflects the results of a host of company activities, including inventory management, debt management, revenue collection, and payments.
How do you calculate the change in working capital?
Net Working Capital Formula
Networking capital formula, also known as just working capital formula, measures the difference between what a business owns and owes in the short term.
The networking capital formula is calculated by subtracting the current liabilities from the current assets. Here is what the basic equation looks like.
Typical current assets that are included in the networking capital calculation are cash, accounts receivable, inventory, and short-term investments. The current liabilities section typically includes accounts payable, accrued expenses and taxes, customer deposits, and other trade debt.
Some people also the choice to include the current portion of long-term debt in the liabilities section. This makes sense because although it stems from a long-term obligation, the current portion will have to be repaid in the current year. Thus, it’s appropriate to include it in with the other obligations that must be met in the next 12 months.
Here’s the basic formula for working capital:
Net Working Capital = Current Assets – Current Liabilities
Working capital is a balance sheet calculation, meaning that every number you need to calculate net working capital should appear on your most recent balance sheet. If you don’t know how to create a balance sheet, use our free balance sheet template.
Change In Net Working Capital Formula
Obviously, a positive net WC is better than a negative one. A positive calculation shows creditors and investors that the company is able to generate enough from operations to pay for its current obligations with current assets. A large positive measurement could also mean that the business has available capital to expand rapidly without taking on new, additional debt or investors. It can fund its own expansion through its current growing operations.
A negative net working capital, on the other hand, shows creditors and investors that the operations of the business aren’t producing enough to support the business’ current debts. If this negative number continues over time, the business might be required to sell some of its long-term, income-producing assets to pay for current obligations like AP and payroll. Expanding without taking on new debt or investors would be out of the question and if the negative trend continues, net WC could lead to a company declaring bankruptcy.
Keep in mind that a negative number is worse than a positive one, but it doesn’t necessarily mean that the company is going to go under. It’s just a sign that the short-term liquidity of the business isn’t that good. There are many factors in what creates a healthy, sustainable business. For example, a positive WC might not really mean much if the company can’t convert its inventory or receivables to cash in a short period of time.
Technically, it might have more current assets than current liabilities, but it can’t pay its creditors off in inventory, so it doesn’t matter. Conversely, a negative WC might not mean the company is in poor shape if it has access to large amounts of financing to meet short-term obligations such as a line of credit.
What is a more telling indicator of a company’s short-term liquidity is an increasing or decreasing trend in their net WC. A company with a negative net WC that has continual improvement year over year could be viewed as a more stable business than one with a positive net WC and a downward trend year over year.
Working Capital Ratio Formula
Here’s an example of how to calculate net working capital, using a sample business called ABC Manufacturing. We start out with the company’s assets and liabilities for the coming year:
ABC Manufacturing Current Assets:
- Cash in the bank: $100,000
- Outstanding accounts receivables: $400,000
- Inventory: $500,000
Total current assets = $1 million
ABC Manufacturing Current Liabilities:
- Outstanding accounts payable: $300,000
- Short-term debt payments due this year: $30,000
- A portion of long-term debt due this year: $25,000
- Other accrued expenses for this year (e.g. rent, payroll, etc.): $400,000
Total current liabilities = $755,000
ABC Manufacturing Net Working Capital = Current Assets – Current Liabilities
$1 million – $755,000 = $245,000
ABC Manufacturing has $245,000 in working capital. The company will have an estimated $245,000 leftover at year’s end after paying all of their expenses and obligations. That means ABC is in a strong financial position for the coming year.
In this example, we calculated working capital for a one-year period, but you can also go with a quarterly or monthly calculation. In that case, you’d include accounts receivables that will be paid within the quarter or month, and you’d include debt payments that are due within the quarter or month.
Change In Capital Formula
You might ask, “how does a company change its networking capital over time?” There are three main ways the liquidity of the company can be improved year over year. First, the company can decrease its accounts receivable collection time.
Second, it can reduce the amount of carrying inventory by sending back unmarketable goods to suppliers. Third, the company can negotiate with vendors and suppliers for longer accounts payable payment terms. Each one of these steps will help improve the short-term liquidity of the company and positively impact the analysis of net working capital.