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Net Working Capital: Managing Your Business’s Financial Health

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Working capital is the difference between your small business’s assets and its liabilities. Calculating your company’s net working capital is one way you — and potential investors — can gauge its financial health. The formula is straightforward:

Net Working Capital = Current Assets – Current Liabilities

But we’ll explain each component with examples to help you see where you stand.

How to calculate net working capital

Let’s break down the formula above:

Current assets refers to a company’s cash on hand or other assets that can be converted to cash within the next year. These may include inventory, equipment, vehicles or other property.

Current liabilities are the obligations or expenses the company must pay within the next year. Those might include the portion of outstanding loans due in that time or amounts owed to vendors or supplies.

“That metric is basically trying to say whether or not you have enough liquid assets on hand to pay your bills that are coming due pretty quickly,” said Brian Hamm, an accounting professor at the University of Illinois at Urbana-Champaign.

Ideally, you want to have more current assets than current liabilities. Businesses of all sizes can monitor working capital to free up cash to reinvest in the company before paying bills, Hamm said.

Another way to measure liquidity would be finding your working capital ratio, which is the proportion of your assets to liabilities.

Working Capital Ratio = Current Assets / Current Liabilities

A working capital ratio near 2.0 would indicate healthy short-term liquidity, while a ratio below 1.0 could signify that the business may soon have trouble paying off its liabilities.

Examples of how to find net working capital

Here are some examples of how a business might use the net working capital formula.

Example 1

Business A has $10,000 in cash, $12,000 in accounts receivable and $5,000 in expenses that are already paid. It has $9,000 in accounts payable and $5,000 in short-term debt payments due within the next 12 months.

Business A
Current Assets $27,000
Current Liabilities $14,000
Net Working Capital $27,000 – $14,000 = $13,000
Working Capital Ratio $27,000 / $14,000 = 1.93

 

Business A has positive working capital and a healthy ratio.

Example 2

Business B has $5,000 in cash, $3,000 in accounts receivable and $2,000 in prepaid expenses. It has $12,000 in accounts payable and $4,000 in other payables.

Business B
Current Assets $10,000
Current Liabilities $16,000
Net Working Capital $10,000 – $16,000 = -$6,000
Working Capital Ratio $10,000 / $16,000 = 0.63

 

Business B has negative working capital and an unhealthy ratio.

Positive working capital may have a downside. In the first example, Business A’s net working capital is a healthy sign that the company is able to cover its current liabilities with its assets. However, if Business A’s assets start to increase while its liabilities continue to decrease, this will demonstrate that its leaders aren’t effectively managing their working capital. If the ratio is anywhere over 2, it can be a sign of a deficiency in working capital management.

High vs. low net working capital

Net working capital and working capital ratio vary by business, and your figures would reflect the inner workings of your individual company. For instance, your working capital ratio would be low if you rely on a business line of credit and keep your cash reserves minimal. Though the ratio would be low, you wouldn’t have a problem drawing from the credit line when bills are due.

Businesses with a large amount of assets in inventory may have a low working capital ratio as well, especially if inventory turnover is typically low. Lengthy accounts payable terms would also lower the company’s working capital ratio.

Other types of working capital formulas

There are a few more working capital formulas business owners could use to see how specific things like inventory and accounts payable impact working capital, Hamm said. Analyzing certain areas of the business could help you pinpoint where you need to make changes.

“Those working capital metrics are more tangible,” he said. “It allows an organization to get their head wrapped around what we can control.”

Here’s a look at additional working capital ratios:

Days sales outstanding

Days Sales Outstanding = Average Accounts Receivable Balance / (Sales/365)

This formula measures the amount of time it takes for a business to collect payments from customers who purchased goods on credit terms. Your average accounts receivable balance would be the average of each month’s accounts receivable balance during the year. Dividing your annual sales by 365 days would equal the daily average sales.

Days inventory outstanding

Days Inventory = Average Inventory Balance / (Cost of Sales/365)

This formula can tell you how frequently your company replenishes its inventory. A low number of days generally means a company is efficiently converting inventory into cash. You would take the average of each month’s inventory balance throughout the year to find your average inventory balance. Dividing your cost of sales, or cost of goods sold, by 365 would determine your daily average cost of sales.

Days payable outstanding

Days Payable Outstanding = Average Accounts Payable Balance / (Cost of Sales/365)

This formula shows the amount of time you can hold onto cash before payment to your vendors is due. You can calculate your average accounts payable balance by finding the average of each month’s accounts payable balance throughout the year. Your total cost of sales divided by 365 equals your daily average cost of sales.

As a goal, aim for low days sales outstanding and days inventory ratios, but high days payable outstanding. You want to collect payments from customers as fast as possible, limit the amount of cash tied up in inventory and hold onto your cash as long as you can before paying bills.

Why is working capital important?

Calculating your net working capital would show you the short-term financial health of your business. If the figure is positive, then you have enough funds to cover your upcoming liabilities.

But if the number is negative, you may not have sufficient capital to pay your bills. Negative working capital could also indicate that bankruptcy may be on the horizon. Tracking your working capital over time would be most effective to identify trends within the business.

When applying for a business loan, you might be asked for your company’s net working capital.  Working capital financing is available for businesses that need help paying bills or purchasing inventory. Working capital financing from traditional banks, alternative online lenders and financing companies usually has short borrowing terms, typically less than a year. However, interest rates and fees may be higher in exchange for shorter terms.

Business financing products such as short-term loans, lines of credit, merchant cash advances and invoice financing can be used to cover working capital needs. Though such loans could help you in a pinch, taking on debt would add to your list of liabilities, Hamm said, and you may have trouble keeping up with payments if you’re already struggling to manage working capital.

“Don’t let working capital management lead you to making a bad business decision,” he said. “At the end of the day, it’s about maximizing your profits and maximizing your cash.”

Improve your working capital

Monitoring your working capital would allow you to see how much you can invest in your business. To maximize your cash on hand, try to “standardize and simplify,” Hamm said.

Standardize: If you offer terms to customers to let them pay at a later date, standardize the amount of time you allow between the sale and payment. Also, regulate when you pay your vendors. Paying your bills on a regular schedule and being able to predict when all customers will pay you would help in better managing your working capital.

Simplify: Limit your inventory to your most popular items to prevent your cash from being tied up in slow-moving or unused items. A simpler product lineup would lower your days in inventory ratio.

Make sure that the steps you take to improve your working capital benefit your business as a whole, Hamm said. For instance, paying your vendors in 45 days rather than 30 days would give you more time to hold onto your money, but could eliminate an early payoff discount that you had been receiving.

Similarly, you could entice customers to pay you faster by offering a discount, but too big of a markdown could reduce your return to the point that the discount isn’t worthwhile.

“That’s going to improve your working capital undoubtedly, but that’s not a good business decision,” Hamm said. “You have to strike the right balance between working capital and your income statement or profit management.”

Working capital is the difference between your small business’s assets and its liabilities. Calculating your company’s net working capital is one way you — and potential investors — can gauge its financial health. The formula is straightforward:

Net Working Capital = Current Assets – Current Liabilities

But we’ll explain each component with examples to help you see where you stand.

How to calculate net working capital

Let’s break down the formula above:

Current assets refers to a company’s cash on hand or other assets that can be converted to cash within the next year. These may include inventory, equipment, vehicles or other property.

Current liabilities are the obligations or expenses the company must pay within the next year. Those might include the portion of outstanding loans due in that time or amounts owed to vendors or supplies.

“That metric is basically trying to say whether or not you have enough liquid assets on hand to pay your bills that are coming due pretty quickly,” said Brian Hamm, an accounting professor at the University of Illinois at Urbana-Champaign.

Ideally, you want to have more current assets than current liabilities. Businesses of all sizes can monitor working capital to free up cash to reinvest in the company before paying bills, Hamm said.

Another way to measure liquidity would be finding your working capital ratio, which is the proportion of your assets to liabilities.

Working Capital Ratio = Current Assets / Current Liabilities

A working capital ratio near 2.0 would indicate healthy short-term liquidity, while a ratio below 1.0 could signify that the business may soon have trouble paying off its liabilities.

Examples of how to find net working capital

Here are some examples of how a business might use the net working capital formula.

Example 1

Business A has $10,000 in cash, $12,000 in accounts receivable and $5,000 in expenses that are already paid. It has $9,000 in accounts payable and $5,000 in short-term debt payments due within the next 12 months.

Business A
Current Assets $27,000
Current Liabilities $14,000
Net Working Capital $27,000 – $14,000 = $13,000
Working Capital Ratio $27,000 / $14,000 = 1.93

 

Business A has positive working capital and a healthy ratio.

Example 2

Business B has $5,000 in cash, $3,000 in accounts receivable and $2,000 in prepaid expenses. It has $12,000 in accounts payable and $4,000 in other payables.

Business B
Current Assets $10,000
Current Liabilities $16,000
Net Working Capital $10,000 – $16,000 = -$6,000
Working Capital Ratio $10,000 / $16,000 = 0.63

 

Business B has negative working capital and an unhealthy ratio.

Positive working capital may have a downside. In the first example, Business A’s net working capital is a healthy sign that the company is able to cover its current liabilities with its assets. However, if Business A’s assets start to increase while its liabilities continue to decrease, this will demonstrate that its leaders aren’t effectively managing their working capital. If the ratio is anywhere over 2, it can be a sign of a deficiency in working capital management.

High vs. low net working capital

Net working capital and working capital ratio vary by business, and your figures would reflect the inner workings of your individual company. For instance, your working capital ratio would be low if you rely on a business line of credit and keep your cash reserves minimal. Though the ratio would be low, you wouldn’t have a problem drawing from the credit line when bills are due.

Businesses with a large amount of assets in inventory may have a low working capital ratio as well, especially if inventory turnover is typically low. Lengthy accounts payable terms would also lower the company’s working capital ratio.

Other types of working capital formulas

There are a few more working capital formulas business owners could use to see how specific things like inventory and accounts payable impact working capital, Hamm said. Analyzing certain areas of the business could help you pinpoint where you need to make changes.

“Those working capital metrics are more tangible,” he said. “It allows an organization to get their head wrapped around what we can control.”

Here’s a look at additional working capital ratios:

Days sales outstanding

Days Sales Outstanding = Average Accounts Receivable Balance / (Sales/365)

This formula measures the amount of time it takes for a business to collect payments from customers who purchased goods on credit terms. Your average accounts receivable balance would be the average of each month’s accounts receivable balance during the year. Dividing your annual sales by 365 days would equal the daily average sales.

Days inventory outstanding

Days Inventory = Average Inventory Balance / (Cost of Sales/365)

This formula can tell you how frequently your company replenishes its inventory. A low number of days generally means a company is efficiently converting inventory into cash. You would take the average of each month’s inventory balance throughout the year to find your average inventory balance. Dividing your cost of sales, or cost of goods sold, by 365 would determine your daily average cost of sales.

Days payable outstanding

Days Payable Outstanding = Average Accounts Payable Balance / (Cost of Sales/365)

This formula shows the amount of time you can hold onto cash before payment to your vendors is due. You can calculate your average accounts payable balance by finding the average of each month’s accounts payable balance throughout the year. Your total cost of sales divided by 365 equals your daily average cost of sales.

As a goal, aim for a low days sales outstanding and days in inventory ratios, but high days payable outstanding. You want to collect payments from customers as fast as possible, limit the amount of cash tied up in inventory and hold onto your cash as long as you can before paying bills.

Why is working capital important?

Calculating your net working capital would show you the short-term financial health of your business. If the figure is positive, then you have enough funds to cover your upcoming liabilities.

But if the number is negative, you may not have sufficient capital to pay your bills. Negative working capital could also indicate that bankruptcy may be on the horizon. Tracking your working capital over time would be most effective to identify trends within the business.

When applying for a business loan, you might be asked for your company’s net working capital.  Working capital financing is available for businesses that need help paying bills or purchasing inventory. Working capital financing from traditional banks, alternative online lenders and financing companies usually has short borrowing terms, typically less than a year. However, interest rates and fees may be higher in exchange for shorter terms.

Business financing products such as short-term loans, lines of credit, merchant cash advances and invoice financing can be used to cover working capital needs. Though such loans could help you in a pinch, taking on debt would add to your list of liabilities, Hamm said, and you may have trouble keeping up with payments if you’re already struggling to manage working capital.

“Don’t let working capital management lead you to making a bad business decision,” he said. “At the end of the day, it’s about maximizing your profits and maximizing your cash.”

Improve your working capital

Monitoring your working capital would allow you to see how much you can invest in your business. To maximize your cash on hand, try to “standardize and simplify,” Hamm said.

Standardize: If you offer terms to customers to let them pay at a later date, standardize the amount of time you allow between the sale and payment. Also, regulate when you pay your vendors. Paying your bills on a regular schedule and being able to predict when all customers will pay you would help in better managing your working capital.

Simplify: Limit your inventory to your most popular items to prevent your cash from being tied up in slow-moving or unused items. A simpler product lineup would lower your days in inventory ratio.

Make sure that the steps you take to improve your working capital benefit your business as a whole, Hamm said. For instance, paying your vendors in 45 days rather than 30 days would give you more time to hold onto your money, but could eliminate an early payoff discount that you had been receiving.

Similarly, you could entice customers to pay you faster by offering a discount, but too big of a markdown could reduce your return to the point that the discount isn’t worthwhile.

“That’s going to improve your working capital undoubtedly, but that’s not a good business decision,” Hamm said. “You have to strike the right balance between working capital and your income statement or profit management.”

 

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