When you’re running a business, you need to keep check of your assets and liabilities on the balance sheet. Staying updated on the company’s liquidity and financial situation can save you a lot of trouble and wrong decisions in tricky times.
Net working capital, also known as working capital, is a significant figure in a company’s finances. It determines the ability of your business to meet its short-term goals and ensure enough funding for long-term operations.
Know what net working capital is, how to calculate it, and why it matters to your business.
What is Net Working Capital?
Net working capital (NWC) or working capital is the difference between a company’s current assets and liabilities on its balance sheet. Some typically calculate NWC by excluding current debt and cash portions.
Think of it as the difference between the short-term assets and current liabilities of the business:
- Current Assets: All assets you can convert to cash within a year, such as cash on hand, raw materials, receivables, currency, inventory, and prepaid expenses.
- Current Liabilities: Any short-term debts you’ll pay within a year, such as rent, utilities, accounts payable, debts, payroll, and other expenses.
When a company has more current assets than liabilities, it has a positive net working capital and a healthier financial situation. The higher your NWC is, the more you are likely to cover current business obligations.
Meanwhile, if you have a negative NWC, which means your liabilities outweigh your current assets, your company might be in trouble in terms of funding future activities and growth.
However, a very high working capital indicates stagnancy in inventory and excess cash, which you must also keep in check.
READ: 11 Smart Budgeting Tips for Small Businesses
Why Does Net Working Capital Matter to Your Business?
Understanding the concept of net working capital lets you determine whether your company is producing enough cash from its daily operations to sustain its capital or drawing cash from assets to fulfil liabilities.
It helps you get a picture of your company’s operational efficiency and financial health. Drastic changes in the working capital may impact cash flow in the financial modelling and corporate valuation of the business.
It’s simple! Companies with higher working capital can invest money in growth opportunities. On the other hand, companies with negative NWC don’t have the resources to pay their creditors or employees.
Every business should aim to have a balanced working capital with enough investments and adequate cash flow.
The ideal NWC ratio is between 1.2 is to 2. Anything higher than two means the company has idle funds. Anything lower than one means it’s struggling to pay its current liabilities.
You can use working capital in several ways, such as investments, expansions, and acquisitions. You can also direct the resources to sales and marketing campaigns, new product research, and so on.
How to Calculate Net Working Capital
The method of calculating the net working capital may differ from business to business. It depends on what you need to include or exclude from current assets and liabilities. The general formula is as follows:
Net Working Capital = Current Assets – Current Liabilities
Another way to calculate this is:
Net Working Capital = (Account Receivable + Inventory) – Accounts Payable
The working capital value will come in the currency of your country.
For instance, if your company has current assets worth $500,000 and current liabilities worth $100,000, the working capital value will be $400,000.
This means the company has the amount of $400,000 for use in short-term needs or funding.
A positive NWC indicates that the company has enough resources to cover its expenses and short-term debts. If all current assets are liquidated, there will be surplus cash to cover extra expenses.
A negative NWC means the company’s current liabilities are greater than its assets. This indicates poor financial performance and problems in paying short-term debts should the need arise for liquidation.
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How to Increase the Net Working Capital of Your Company
The easiest way to increase the net working capital of your company is by increasing its current assets. You can do this in several ways:
- The simplest way is to save cash. Reduce operational expenses to save up additional cash. One of the ways to do this is by getting a trustworthy domain at a reasonable price.
- Build inventory reserves and prepay expenses.
- Reduce bad debt write-offs by choosing the right customers to extend credit to.
- Decrease short-term debts by researching credit terms and reusing company funds.
- Incentivize receivables and improve inventory management.
- Work with trustworthy, long-term vendors for better deals and discounts such as top-tier solutions for your online needs.
- Build a business line of credit for easy access to funds.
- Get business credit cards to earn points, rewards, and cash backs.
- Plan expenses better by timing expansions or campaigns smartly.
Improve the Financial Health of Your Company!
Keeping a stable and balanced net working capital can help improve your company’s financial health.
By boosting cash flow and reducing inefficient resource utilisation, you can plan how to work out your working capital and optimise company finances. Doing so lets you plan activities like exploring new markets, expanding production or creating extensive marketing campaigns well.
Keep your working capital optimal to mobilise excess cash while building a surplus asset repository to see your business through tough times.