According to statistics, 82% of business failures are due to insufficient cash flow and a lack of net working capital (NWC).
Perhaps more alarmingly, global reports show that more than 90% of businesses may not have a transparent view of their cash flow.
If you are looking to optimize your cash flow, one of the financial metrics that you should be looking at is net working capital. By calculating NWC, you will get a bird’s eye view into your business’s short term ability to meet its financial obligations.
What’s more, once you know how to calculate net working capital, you may be able to take steps to improve this metric. With that, you will improve the health of your business, and be able to attract capital investment if you so wish.
Ready to learn more about net working capital and what it can do for your business? Read on.
What is Net Working Capital?
The first question is, what is net working capital?
NWC is the difference between a business’s total current assets, and its total current liabilities. NWC stands as a measure of a business’s liquidity, its operational efficiency, and its ability to meet current financial obligations.
To understand why this is, let’s take a look a what current assets and liabilities consist of.
Definition of Current Assets
Current assets are the assets listed on a balance sheet that are considered to be short term assets which can be converted in to cash within a year. Cash itself is also a current asset. Here are some common examples of other current assets:
- Cash equivalents (money market funds, treasury bills, commercial paper, and short-term government bonds)
- Marketable securities
- Accounts receivable
- Inventory or stock
- Prepaid expenses
If a business holds properties that are expected to sell within 12 months’ time, these also constitute current assets.
Definition of Current Liabilities
Current liabilities are comprised of all liabilities found on the balance sheet that are due within the year. These include:
- Accounts payable
- Accrued expenses
- Taxes payable (including payroll and sales tax)
- Current portion of long-term debt
- Bank overdraft
- Current maturities of long-term debt
- Credit card debt
- Dividends payable
- Customer deposits
Anything else you owe which is due to be paid within the year is typically considered a current liability.
How to Calculate Net Working Capital
The net working capital formula is simple. As mentioned above, NWC equals current assets minus current liabilities.
Current Assets – Current Liabilities = Net Working Capital (NWC)
However, depending on the application, you may want to tweak which current assets and liabilities are included in the formula to arrive at a working capital figure that reflects the data you need.
The broadest way to calculate working capital is by subtracting all current liabilities from all current assets. However, to refine your result, you may wish to exclude certain current assets or liabilities.
For example, one common variation of the formula for NWC is:
Accounts Receivable + Inventory – Accounts Payable = Net Working Capital
This formula will yield a better indication of the relationship between a business’s payable expenses and its receivable income and available inventory.
The exact method for how to calculate net working capital will often depend on what an analyst wishes to reveal or pinpoint through the calculation.
How to Calculate Net Working Capital Ratio
Another helpful metric you can calculate is the NWC ratio. This is the percentage of a company’s current assets to its short-term liabilities.
To calculate it, simply divide your business’s current assets by its current liabilities.
Ratios of between 1.2 – 2 are considered optimal. Lower than this and the ratio will indicate illiquidity and danger of insolvency. Higher ratios than 2 show that current assets are not being leveraged to further company growth.
Why is NWC Important?
Being able to analyze the NWC of your business is invaluable, as this will give you an insight into its cash flow and its ability to weather the year’s financial demands.
What’s more, having a clear idea of your business’s NWC will also indicate whether you are in a position to increase capital expenditure. If your net working capital ratio is above 2, then you may want to look into profitable avenues for capital expenditure so that your current assets can begin to stimulate growth rather than stagnate.
According to research, reducing excess working capital could pay for a 55% increase in capital expenditure in certain organization—something which could significantly drive expansion for your business if implemented well.
On the other hand, if your NWC and its ratio are low, or even negative—you will need to take into action some urgent measures to improve liquidity before you think of increasing capital expenditure.
How to Improve Your Net Working Capital
If your NWC is low, this shows that your business is in a precarious financial situation. However, there are several things you can do to improve this metric.
Refinance Short-Term Debt
If short-term debt is making your net working capital formula liability heavy, you can look at refinancing. Refinancing short-term debt into long-term debt will shift the numbers and improve your available net working capital.
Secure a Working Capital Loan
Another way to resuscitate your business’s net working capital is to take out a working capital loan.
If you are able to secure this type of loan with long terms, you will be able to boost your business’s current assets in the form of cash, while not adding substantially to its current liabilities.
Sell Long-Term Assets for Cash
If your business is sitting on unproductive long-term assets, selling these will instantly shift your business’s net working capital ratio to your favor.
According to the Small Business Association, over-investing in fixed assets is one of the top causes of business bankruptcies, so take a careful look at what your business owns and decide if it’s a profitable asset or whether it should be sold.
Boost Inventory Turnover
Another strategy for improving net working capital is to boost inventory turnover. This is not always as simple as selling assets, refinancing, or securing funding. However, the gains can be substantial, as inventory will realize an appreciation when sold.
For example, if you have $5,000 worth of stock on hand, once this is sold, it should bring in a cash value of up to $10,000.
Are You Struggling With Cash Flow? Consider Applying for Accounts Receivable Financing
Depending on your business, sometimes it’s not possible to fix cash flow and increase net working capital numbers overnight.
However, If you are struggling with cash flow, you can also look at accounts receivable funding. The way this works is simple. If you have accounts receivable that you would like to turn into cash, you can sell your unpaid invoices at a discount.