There are many ratios, formulas and financial statements that business owners should know. It can seem overwhelming, but it’s wise to focus on the more important ones, like the net working capital formula. This crucial formula shows businesses’ liquidity and can be found by subtracting current liabilities from current assets. Liquidity has a few meanings, but it’s most common one is the ease in which assets can be converted to cash. This guide will discuss the net working capital formula, relevant resources, case studies, negative working capital and mistakes to avoid.
Net working capital formula
The simple formula for net working capital is current assets – current liabilities. This formula is the broadest of ways to calculate it. It includes all current assets like cash, accounts receivable, inventory and more. It also accounts for current liabilities like accounts payable, short term debts and interest payable. Some accountants choose to include long term debt obligations into the current liabilities category as most businesses pay monthly installments on these debts.
What if a business wants to fine tune it’s working capital formula? This can be accomplished by using two precise formulas:
NWC = Current Assets (less cash) – Current Liabilities (less debt)
NWC = Accounts Receivable + Inventory – Accounts Payable
One advantage of using the first alternative equation is excluding extremely liquid assets and debts like cash or short term liabilities. A business will be able to pinpoint which items are more liquid in comparison to others. This formula will also allow the business to analyze its non-reserve amounts.
The second formula is even more precise and only includes 3 accounts which are accounts receivable, inventory, and accounts payable. This formula’s main advantage is that it enables businesses to focus on short term revenues and liabilities that it hasn’t received yet. Under the accrual accounting system, a business can record accounts receivable, which reflects short term billed revenue that it hasn’t received yet. This accounting system also allows business to record accounts payable, which shows short term items that the business has promised to pay.
Details matter in business and accounting, which is why this last formula is so important. Businesses that break down each part of the net working capital formula will be able to fix underlying problems. This will set the foundation for them to eventually fix larger problems on a larger scale. Another smart idea would be to calculate working capital with each equation and compare the amounts on a monthly basis.
Net working capital resources
Some resources include using Excel or Google sheets to start calculating net working capital. In fact, some companies like Wall Street Mojo offer free working capital excel templates and calculators.
As discussed in a prior article, the balance sheet is a snapshot of what the company owns and owes. Businesses use this financial document to record and measure their current assets, accounts receivable, current liabilities and accounts payable. This sheet also serves as the building block for important ratios like the current ratio. The current ratio is similar to net working capital as it’s a measure of short term liquidity and it’s formula is:
Current Ratio = Current Assets/Current Liabilities
An optimal current ratio is any amount above 1. This means that the company has enough reserves to pay current debts and is very liquid. Many people can confuse this ratio with working capital, but it’s important to realize that working capital is a dollar amount. For example, Company A has $90,000 in current assets and $60,000 in current liabilities. Its current ratio is 1.5 and its working capital is $30,000. Both a current ratio above 1 and positive working capital mean that’s it’s very liquid and has sufficient cash reserves.
Similar to the balance sheet, an income statement is an important financial document that impacts working capital. An income statement shows the relationship between revenue, inventory, and cost of goods sold (COGS). Businesses that study this statement can measure inventory impact on gross profit margins. They can look for ways to reduce direct costs like product materials and labor costs. From there, they can obtain a precise net working capital figure by calculating it with just accounts receivable, accounts payable and inventory.
Current liabilities are short term liabilities that the company owes like wages payable, accounts payable, rents, utilities, interest payable and must be paid within a business cycle or calendar year. It’s important to note many businesses have cycles that differ from the calendar year. So current liabilities are those that must be paid within the shorter of the two time frames. Some other examples of current liabilities include dividend payments, capital leases due within a year and long term debt that will be due. A common capital lease example is a company borrowing a necessary piece of equipment for a temporary time period that it intends to eventually return.
Current assets are short term assets that the company owns like cash, investments like ETFs, accounts receivable, inventory and prepaid expenses. Current assets are defined by how quickly they can be liquidated during the calendar year or business cycle, whichever is shorter. Current assets also include intangible assets like goodwill and trademarks. This category doesn’t include collectibles or real estate, which are illiquid assets.
Net working capital mistakes to avoid
Net working capital on a high level might seem simple, but there are some mistakes that businesses should avoid. One mistake applies to seasonal businesses like fireworks retailers, which experience most of their revenues during the summer. A possible way to fix this is to only include ratios that reflect seasonality. A business could separate their books based on high and low seasons.
Another mistake is not accounting for operational changes like the staff and inventory fluctuations. Accounts receivable is a crucial factor that impacts net working capital and it can be altered if people in the accounts receivable department are laid off or not punctual. Sometimes, vacationing employees can delay accounts receivable processing which will impact the final net working capital figure. Businesses can overstock their inventory to prepare for price increases. It wouldn’t be prudent to use historical figures to calculate this figure.
Supply chain inefficiencies
One overlooked error is to not factor in the supply chain. A proper supply chain can be a well-oiled machine that can ensure positive net working capital. Therefore, it makes sense to use proper supply chain practices like having a proper Enterprise Resource Planning or ERP process. This will make it easier to manage slow areas in the supply chain and improve efficiency.
An ERP allows different departments like marketing, finance and IT to connect with one another. It also enables businesses to monitor and edit important supply chain statistics like just in time (JIT) inventory. JIT inventory planning helps companies save money by reducing the amount of unnecessary inventory.
Off-balance sheet items
A final working capital error to avoid is not including off-balance sheet items. For example, some companies don’t include all debts, like unfunded retirement obligations on their balance sheets. Long term monthly payments can greatly impact net working capital and this can give businesses a false sense of security. This can confuse a business even if it has a positive working capital figure. Similarly, not measuring working capital on a yearly or monthly frequency is a big mistake that could cause bankruptcy over time.
Negative working capital
An optimal situation is for a business to have positive working capital and negative working capital demonstrates that a business can’t keep up with its current obligations. Long periods of negative working capital could force a business to sell long term assets to pay for short term expenses like wages payable. It would also prevent expansion, attracting investors and could lead to bankruptcy.
Short periods of negative working capital aren’t terrible, as long as the business has an upward trend. For instance, it would be better to see a company with negative working capital increase its amount on a linear trend than the opposite. A positive working capital firm might look good, but it would run into trouble if it’s net working capital has a strong downward trend. Positive net working capital isn’t always an ideal scenario, especially if the business can’t easily liquidate its inventory to pay creditors. Responsible short term financing like a line of credit is one way that could help negative working capital companies progress on an upward trend.
Three simple ways for a company to maintain a positive working capital trend include:
- Decreasing accounts receivable time frame
- Sending unsellable inventory back to suppliers
- Negotiating longer accounts payable time frames.
All of these factors will improve short term liquidity.
Dell capital case study
Counterintuitively, negative working capital can be good depending on the company’s business model. During 2004, a famous computer company called Dell was able to create and sell personal computers directly to consumers for more than 30 days until it needed to pay its suppliers. These sales gave Dell large accounts payable balances, which resulted in negative working capital. Despite this, the company was able to make and sell computers by essentially using its suppliers’ money without pulling from its cash savings. Dell was revolutionary at the time because it sold directly to the customer, unlike its competitors IBM and Sun Microsystems Inc.
This quick payment cycle reduced component costs, which were passed in the form of price savings to consumers. High quality and affordable computers gave Dell a significant competitive edge at the time.
Net working capital among different industries
Every company and industry varies, which can alter working capital. For example, large retailers like Walmart generally don’t worry about this figure since their customers usually pay on the spot. However, high volume industries like retail must manage their inventory properly or risk running out of business. If a retail business has strong sales but lacks inventory, it will miss out on revenue opportunities and anger customers. Therefore, retail companies should pay special attention to their cost of goods sold and inventory turnover ratios.
The cost of goods sold will show businesses the various direct expenses of creating a product. This figure lays the foundation for two important ratios: days in inventory and inventory turnover ratio. The inventory ratio formula is the cost of goods sold/average inventory. This shows companies how many times they turn over or sell all their inventory in a year.
A company with a cost of goods sold of $40,000 and an average inventory of $20,000 will have an inventory ratio of 2. This means that specific company sells all of their inventory twice a year. The days in inventory ratio is found by simply dividing 365 (days of the year) by the inventory turnover ratio. This tells companies how many days it will take before selling all its inventory.
Insurance companies have different net working capital standards since they are paid monthly, upfront premiums. While this provides upfront revenue, these companies have to adjust to high and infrequent expenses when claims are filed. Therefore, it makes sense to have ways to keep enough cash on hand to cover these. One way insurance companies ensure they have enough reserves is to invest in the stock market. Most insurance companies invest a percentage of revenues, so they can grow the funds over time and provide a buffer.
There are many ratios and formulas that can make or break a business. It can seem daunting at times, but it’s wise to focus on the most important ones first. Net working capital ties information from the balance sheet and income statement to measure a company’s liquidity. This will allow companies to properly invest their funds and reduce costs. Net working capital is relatively simple, but there are many ways to interpret and measure it. This guide has discussed many working capital tips, resources, case studies, negative working capital and mistakes to avoid.
Disclaimer: This is not tax advice, but general education. Consult a CPA or tax professional for tax advice.