Reviewing your business account is a great way to determine how well your business is doing. One meaningful way to gauge your business’s success is by determining your net working capital.
Your business’s net working capital determines your business’s liquidity and ability to handle current business obligations, like paying bills. As a business owner, you probably believe in the misconception that using net working capital to determine the state of your business finances will take hours of tedious calculation.
However, with the correct method, you can correctly calculate your net working capital in a few minutes! In this article, we have provided all you need to know about net working capital and how to calculate your business’s NWC in five minutes!
What Is Net Working Capital?
Before you can calculate your net working capital and use the result to determine the financial state of your business, you first need to understand what net working capital is and why it is crucial. So, what exactly is net working capital?
Put simply, Net Working Capital (NWC), also often shortened as Working Capital (WC), is the difference between your business’s current assets and current liabilities. It is used to determine an organization’s financial health and liquidity at a certain period during the business year.
Net working capital is used to measure a business’s short-term financial health. It gives business owners and teams an overview of the current operational efficiency, offering an easy way to scope areas of the business that need to be improved and scaled.
Net working capital is derived from the slew of assets and liabilities in the organization’s records or business balance sheet. To get an accurate net working capital figure, you must ensure you have the correct components in your business’s balance sheet.
Current liabilities and assets are used to calculate a business’s net working capital. Net working capital, current assets, and current liabilities may sound like a lot of terms to understand, especially if you have no prior knowledge of what they mean.
However, these business terms are not only essential but also surprisingly easy to understand.
Components of Net Working Capital
As previously mentioned, current assets and current liabilities are factored into the equation when calculating the NWC. However, these components may differ in various businesses and often vary with the business sector.
1. Current Assets
Current assets are listed in a business’s balance sheet under company-owned assets. These are valuable assets that can be converted to cash in one year. Essentially, current assets are those assets that last only for a year and can be quickly liquidated or converted to cash.
Current assets are important to businesses because they provide the funds they use to make daily payments or settle short-term operating expenditures and expenses. They play a significant role in keeping a company in business.
With current assets, investors and lenders can analyze a business’s value and the risk associated with its operations. These assets offer insight into an organization’s liquidity, making it easy to know the business’s financial position.
There are many assets that are considered current assets. Some are:
- Cash and cash equivalents: The money an organization has at hand counts as a current asset because it can be used to pay off bills. Cash equivalents may not be money, but they can be quickly converted to cash. These cash equivalents have economic value with low investment term periods. They include certificates of deposit, money market funds, short-term government bonds, and treasury bills.
- Inventory and supplies: A business’s inventory represents unsold finished products, semi-finished products, or raw materials. Although inventory is by default considered a current asset because it can quickly be sold for cash, its liquidity varies with sectors and products. For example, it will be easy to sell a thousand wristwatches within a year than it will be to sell a hundred bulldozers.
- Prepaid expenses: Settling expenses creates current assets because they carry short-term value. Examples of prepaid expenditures include rent and insurance.
- Accounts receivable: This includes the money owed to the business by its customers. Account receivables cover all inventory items purchased by clients but not paid for. These credits must be settled within a year.
- Marketable securities: These include short-term investments that can be quickly converted to cash without impacting their market value. Marketable securities include stock, bonds, and preferred shares.
Other forms of liquid investments in your business also count as current assets. As long as it promises quick cash within 12 months, it can be categorized as a current asset. Current assets are a big part of the net working capital. To calculate your NWC, you must have an accurate current asset figure.
To calculate your CA,
CA = Cash + cash equivalents + inventory + accounts receivable + marketable securities + prepaid expenses + other liquid assets.
2. Current Liabilities
Current liabilities are the second most crucial component of the net working capital. They are a company’s expenditures or financial obligations due in the next year. Current liabilities are those short-term financial obligations usually settled using the company’s current assets. They are generally also used to determine how liquid a business is and if these liabilities can be paid during the business’s operating cycle (typically twelve months).
Reviewing your current liabilities is a great way to plan your finances and determine your financial ratio. It gives insight into your business’s solvency and liquidity strengths and weaknesses. Like current assets, current liabilities are made up of different examples. These include:
- Accounts payable: Debt payable to a third party. This includes the total amount of short-term debt for unpaid invoices to creditors and suppliers. Accounts payable can range from raw materials and property taxes to electricity bills and other operating expenses owned.
- Income tax payable: Income tax is owed to the government. When it is unpaid, it becomes a current liability until it is paid off during the same year.
- Accrued expenses: These are expenses that are recorded in the balance sheet but not yet paid. Accrued expenses are recognized short-term financial obligations to a third party that will be paid using current assets. An example of accrued expenses is wages payable.
- Bank account overdrafts: This includes the short-term bank advance required to settle all outlined overdrafts. Overdrafts are gotten by issuing checks that are an excess of what you have available in your bank.
- Short-term loans: All financial loans due in the next twelve months.
- Payroll liabilities: Payroll liabilities include staff benefits like a retirement plan, health insurance, and Medicare payment.
- Unearned revenue: This includes money received in a business for undelivered goods or services. As long as your company receives payment for products yet to be delivered to the customer, you have astounding unearned revenue.
- Sales tax: Sales tax is a business’s responsibility to the government. They are charged to clients after a sale and are paid to the government.
A business’s current liability also involves interest payable, payroll taxes and dividends declared. Essentially, a business’s current liability is a total of an enterprise’s obligations or debts due within a year (which is the typical business cycle.
To calculate current liabilities,
Current Liabilities= Notes payable + Accounts payable + Accrued expenses + Unearned revenue + Current portion of long-term debt + other short-term debt.
How To Calculate Net Working Capital In Five Minutes
Now that you know all the components that are necessary to calculate your business’s net working capital, doing the required calculations is a brisk walk in the park. These calculations are so easy that you can get them done in five minutes or less!
The generally accepted and broad formulae calculation is a simple process that involves taking away your business’s current liabilities from the current assets. In other words
Net working capital = Current Assets – Current Liabilities
If a company has current assets totaling $220,000 and current liabilities reaching a total of $180,000, the NWC= $220,000 – $180,000= $40,000 The net working capital, in this case, is $40,000.
It’s that simple!
As long as you have the necessary components on your balance sheet to give you an accurate total of your assets and liabilities, you will have no problem calculating your NWC. Translating the NWC is just as easy as calculating it.
The rules are pretty simple. A positive net working capital figure means a business has enough liquid assets to cover its current liabilities. This figure often starts from 0 and indicates the business has more current assets than liabilities.
On the flip side, a negative net working capital means a business does not have enough current assets to settle its current liabilities. If the negative figure subsides, the business might become bankrupt as it will be unable to keep up with necessary operations.
Although this is a widely accepted method of calculating the net working capital, many businesses also adopt different approaches. These other methods are a variation of the standard net working capital formula (NWC= current assets – current liabilities) depending on what the financial analyst wants to remove from or add to the formula.
One variation of the formula is:
Net Working Capital = Current Assets (less Cash) – Current Liabilities (less Debt)
This formula excludes cash and outstanding debt from the equation, leaving other components to reflect in the formula. This gives the business oversight over different areas of the company’s financial health.
Another formula that is commonly used is:
Net Working Capital = Accounts Receivable + Inventory – Accounts Payable
This formula is not always generally used, but it plays a massive part in determining business financial health and tracking business cycle changes.
Importance of Net Working Capital
The Net Working Capital is undoubtedly one of the best progress-gauging metrics a business can use. It helps companies to understand their credit and debt capacities to create the best opportunities in their organization.
Some importance of Net working capital include:
- Track funding ability: It is no news that the NWC is crucial in determining if a company has enough assets to fund its financial obligations. It helps an organization track how its financial disposition changes over time while determining the best ways to stay out of debt.
- Determine debt capacity: This is handy for creating an investment plan, determining the best negotiation terms with suppliers, and calculating how liquid the business is.
- Building a financial model: Are you considering revamping your business’s financial cycle? Knowing your net working capital is a great way to start. It helps understand corporate valuation and use the provided information to build an operational, financial model.
How To Improve Net Working Capital
A low NWC doesn’t exactly spell doom for your business. If your NWC is lower than you would like, it is still redeemable so long as you adopt the necessary practices to foster improvement in your business’s financial operations.
So, what are the best ways to improve net working capital?
- Document all financial processes. This will give you hard evidence to look back on and review all actions taken
- Create a policy to reduce operational costs and expenses. This will reduce current liability and maximize your current assets.
- Return unused raw materials or inventory to suppliers in exchange for a refund. Do this early in your business cycle.
- Collect necessary payments from debtors to increase your working capital
- Don’t purchase stock in excess. Make inventory purchases at the eleventh hour to reduce the cost of inventory. However, this will require multiple shipping payments as you will need to make stock purchases in bits and pieces. To minimize shipping payments, you should work with a supplier closer to you.
- Be familiar with the company’s financial cycle
To improve your net working capital, you must also be familiar with actions that adversely affect the NWC. Some factors that create adverse effects include:
- Depleting cash in current assets
- Letting debt lay fallow
- Reducing payment terms
We Offer The Working Capital Solutions You Need
Net Working Capital or Working Capital is an integral part of your business. It plays a significant role in ensuring you can finance your business easily and keep it out of reach of debt and liabilities.
To fulfill your short-term obligations and ensure the success of your business projects, you need sufficient working capital. As a small business seeking financial support, it can be very difficult to get a loan for operations like heavy equipment finance, start-up, or business expansion.
However, where other lenders may turn you away, at Coastal Kapital, we have the perfect loan solutions for your business. We offer many working capital financing options tailored to meet your business needs. We provide a fast credit of up to $500,000 with an extended loan term and fast processing.
At Coastal Kapital, we are financial experts with secure loan options that offer your business the growth opportunity it needs. Whether you require restaurant financing or enough capital to extend or start a tow truck business, we have loan options tailored to suit your needs.
Let us equip you with a working capital loan that suits your needs. To get started, fill out an application form on our website.