Net working capital: How to calculate it and why it’s important
- •What is working capital?
- •Why does working capital matter?
- •How to calculate working capital
- •Advantages of working capital
- •Limitations of working capital
- •Example of working capital
- •What does negative working capital mean for your business?
- •How to improve your working capital
- •Expand your business whilst reducing costs with Airwallex
Keeping your business running and thriving requires planning. This is why entrepreneurs and business owners work to better understand the ins and outs of net working capital.
What does it mean? How much do I need? Is it even that important?
Once you understand what net working capital is, you can answer all those questions and stabilise your business’s finances. And stability will help your operations not only run smoother but also last for the long term. Closing a business because you made mistakes that you could have easily prevented is never fun.
But first things first — net working capital and working capital are synonymous. Both represent the difference between your current liabilities and your current assets. However, some financial analysts define net working capital a little more narrowly than others.
Let’s explore the matter.
What is working capital?
Working capital is what keeps a business up and running while it has expenditures.
Most businesses have customers who owe them a little (or a lot of) money. But you can’t always rely on customers to immediately pay you what you’re owed. Nevertheless, the lights need to stay on somehow.
That’s what working capital is. It’s the capital your business runs on while you’re both earning and spending money.
With working capital, you have the option to restock your inventory after selling goods. This is true even if customers purchase by signing up for payment instalments, so you don’t get everything you’re owed immediately. Your working capital allows you to keep your business operating regardless.
Net working capital is quite similar to (if not the same as) working capital, but it has a slightly narrower definition. Net working capital represents the assets you have, not just your on-hand cash. Here are a few examples:
Balance in your bank account
Amount of on-hand cash
Any financial investments
Your accounts receivable
Both net working capital and working capital represent your business’s ability to continue operating while also paying its debts.
Why does working capital matter?
The main goal of any small- to medium-sized business (SMB) or large enterprise is to return money to its investors. When you think about it, it makes sense that investors pay attention to business owners who do more than just keep the lights and water on.
Investors look at businesses that have a strong chance of growing and thus earning more in the future. That earned money will eventually flow back to the investor to replace what they funded.
Working capital keeps a business up and running, but any entrepreneur understands that the net working capital amount determines a business’s debt capacity. Or in other words, how much is this business really worth? And if it needs to handle debt down the road, what can it liquidate to pay it off?
Net working capital and working capital also determine the direction an investment should go and whether suppliers can influence negotiations.
How to calculate working capital
Now that you know what working capital is and why it matters, let’s look into how to calculate it.
First, you have to identify your current assets and liabilities. But what exactly are they?
In accounting terms, a current asset is a business’s cash, as well as all the goods it has that it can convert into cash within a short period (12 months). This also includes incoming earnings.
When you look at a business’s balance sheet, you’ll find its liquidity, with each asset having a unique liquidation amount.
Here are examples of current assets:
Cash. This includes the money in your bank account as well as checks or other forms of customer payment that you haven’t deposited yet.
Accounts receivable. Your total accounts receivables is the money you’re currently owed and receiving through accounts minus the allowances that likely won’t be paid.
Notes receivable. This could be short-term loans (ones that expire within one year) to suppliers or customers.
Other receivables. These include any cash advances you give to employees, insurance claims and income tax refunds.
Short-term investments. These usually entail investments that a business intends to sell within 12 months.
Marketable securities. This includes money market funds or US Treasury bills.
Inventory. This indicates raw materials (e.g. textiles), works in progress and finished goods.
Prepaid expenses and advance payments. This could mean prepaid insurance premiums or purchases you’ve set in place for the future.
As for liabilities, which are on a separate part of a balance sheet, you’ll see short-term debts (again, within a 12-month period). These liabilities usually refer to payments you owe suppliers, your taxes, any financial charges and more.
Here are examples of current liabilities:
Notes payable (within 12 months)
Loan interest payable
Loan principal owed within one year
Variable accrued expenses
Advance customer payments for any goods or services that have yet to be delivered (e.g. deferred revenue)
Here’s the working capital formula:
Current assets − Current liabilities = Working capital.
If your result is in the negative, this means your business will likely need to pursue third-party capital (such as a bank loan) to pay any outstanding debts.
Advantages of working capital
Next, we’ll examine some advantages of working capital.
Businesses often experience financial hardship when they have an ineffective working capital management policy.
Working capital management monitors accounts payable and receivable, stocks, debt and more to ensure liquidity in the business. If the business needs cash for any short-term debts or operations, it’s available at any time.
Avoids operational interruption
Working capital allows you to keep your operations moving without any stops. Better yet, detailed information about your working capital (e.g. how much you have) allows you to make sound business decisions concerning where to put your time and money.
Ultimately, this knowledge gives you an advantage over your competitors.
Properly applying your working capital allows you to increase your profit in the long run. This is because you can better manage your inventory and thus avoid failure in your operations.
Collecting and paying trade receivables on time are key aspects of managing your working capital, too. That’s because you’re properly allocating cash and managing what comes in before it goes out.
Improves financial stability
Because working capital is essentially an assessment of money going in and out, you can better allocate your business’s cash.
Working capital also allows business owners to avoid legal troubles that may arise if they lack enough of it. When you have more than enough working capital, you can unlock opportunities that may otherwise be unavailable.
Limitations of working capital
Here, we’ll delve into some limitations of working capital.
Working capital includes only items of monetary value, such as finished goods, debts receivables and more. When determining your working capital, you don’t consider nonmonetary items such as the impact of recessions and governmental policies affecting your particular industry.
Working capital is naturally non-situational. It takes time to respond to any changes in the market, and working capital doesn’t acknowledge the impact it takes on profit due to slower business operations.
Working capital relies on data, so your strategy holds no relevance without concrete numbers. One example is with trade receivables. You need your date of sale, number of days in a grace period, penalty amount for unfulfilled payments and more.
Example of working capital
Let’s say your total current assets equal $740,000. This includes cash, finished inventory, raw materials and accounts receivable.
However, your current liabilities equal $405,000. This might be for employee wages, business taxes, office rent, utilities, subscriptions and any debts due within the year.
Your working capital would then total $335,000. Following the formula above, your current assets amount ($740,000) minus your current liabilities amount ($405,000) equals your working capital ($335,000).
What does negative working capital mean for your business?
Several risks accompany lack of control over your working capital. Your cash can become negative, which threatens the efficiency and stability of your overall operations.
It’s vital that you prevent a deficit in your current assets to ensure your balance remains positive.
Here are some tips to help you maintain a positive current asset value:
Know your business’s financial cycle and cash flow (what’s coming in and what’s going out).
Document all your business processes so that you have content and data to reference if things go wrong.
Instate a policy that controls the reduction of your expenses and costs.
Negative working capital could result in laying off workers, paying suppliers late or shutting down warehouses or stores. That’s why you want to ensure your current assets remain positive, and doing so requires favourable business conditions.
This will help you meet customers’ needs, maintain trusted relationships with suppliers and vendors, and keep up with market growth.
How to improve your working capital
If your working capital starts to decrease from a lack of sales, or if you want to increase it for project-related reasons, it’s time to think of ways to improve it.
You can improve your working capital in one or two ways:
Reducing your current liabilities
Increasing your current assets
One way to increase your current assets is by taking on long-term debt. The word “debt” might seem frightening, but long-term debt will actually increase your current assets by adding to your business’s available cash and not drastically increasing your current liabilities.
To reduce your current liabilities, you can also refinance your short-term debt to long-term debt. Because your debt is no longer due within a 12-month period, your current liabilities will decrease.
Another way to increase your current assets is to sell non-liquid assets for cash. And as stated earlier, when you have more cash, you have more working capital.
We recommend managing your inventory well to reduce potential overstocking as well as to decrease the likelihood of your business writing off items. This relates to reducing your overall expenses, which in turn reduces your current liabilities.
Additionally, we suggest automating your payment monitoring and accounts receivable. As a result, your cash flow will increase, and you won’t have to dig into your working capital as often to cover your day-to-day operations.
Expand your business whilst reducing costs with Airwallex
Our multi-currency account aligns with more than 11 currencies, which makes it easier than ever to manage your money domestically and internationally. And if your business ends up growing with the potential to expand, our platform will support you along the way.
Related article: How to Perform ROI Calculation
How to Hire for Success When You’re an Unknown Startup
Net revenue retention and 3 things every venture capitalist looks...