HOW TO CALCULATE NET WORKING CAPITAL: Definition, Calcualtion & Formula

how to calculate net working capital
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Net working capital is an account that shows the financial state of a business. With just this simple definition, you already understand how important net working capital is since every business’s ultimate goal is to make a profit. Hence, in this post, I will educate you on how to calculate your business’s net working capital; how to put the capital on a balance sheet; how to get the capital ratio and cash flow; and lastly, how to get this capital from an income statement.

How to Calculate Net Working Capital 

Working capital is typically a term that every business that wants to survive an economic downturn should have knowledge of. This is because the net working capital, as well as the cash flow, show different parts of a business’s financial health. While cash flow measures how much money a company generates over a period of time, working capital does not. Working capital is the difference between the company’s current assets and its current liabilities. 

You can simply calculate your net working capital by subtracting current liabilities from current assets. This is exactly how it is listed on the company’s balance sheet. The current assets include cash, accounts receivable, and inventory. The current liabilities include accounts payable, taxes, wages, and interest owed.

A business that typically maintains good working capital will likely have a greater capacity to withstand financial challenges. Therefore, it’s important that every business takes a special interest in the dealings of its net working capital. 

Understanding Net Working Capital

Net Working capital is also used to fund operations as well as meet short-term obligations. In a situation where a company has enough working capital, it will be able to pay its employees. The company will also be able to pay its suppliers. Meet other day-to-day obligations like interest and tax payments. 

Another important use of working capital is to fund business growth without actually borrowing funds. When your business doesn’t need to borrow money to run its activities, it doesn’t only show a good net working capital. This also typically builds your credit score, making it easier for your business to qualify for loans.

The net working capital also typically measures your business liquidity, operational efficiency, and financial health at that period. This is because if your business has a strong and healthy net working capital, it has a good stance for growth and yielding investment. Another benefit of working on your net working capital is that you avoid the risk of going bankrupt. This is because if your company’s current assets weigh more than its current liabilities, then your net working capital is kicking and healthy.

How to Calculate Net Working Capital from a Balance Sheet

Working capital is also the same as net working capital (NWC). Like I said above, it means the difference between a business’s current assets and liabilities. These assets include cash, accounts receivable (customers’ unpaid bills), etc., and its current liabilities, like accounts payable and debts. The calculation for working capital on balance is thus:

Working capital = current assets – current liabilities.

For instance, if a construction company’s balance sheet has 400,000 total current assets and 300,000 total current liabilities, the company’s working capital is 100,000 (assets – liabilities).

How to Calculate a Net Working Capital Ratio 

Basically, how you calculate the net working capital of a business is an easy task. It’s the same as understanding the definition of working capital itself. How to calculate the net working capital ratio is thus:

Working Capital Ratio = Current Assets/Current Liabilities.

The working capital ratio formula basically shows the ratio of assets to liabilities. This means that it asks the question, which is, what is the maximum number of times a company can pay off its current liabilities with its current assets? This example below with figures will give you more insight into how to calculate the ratio of your working capital. 

From the construction company’s balance sheet above, if their working capital is 400,000 to 300,000, then the working capital ratio of the company is 1.5.

You should master the net working capital ratio formula. This is because just seeing it on paper can be very tricky. Especially in situations when two companies with very different assets and liabilities look the same. If you rely on their working capital figures alone, you will get an incorrect answer by misplacing them. However, if you know the calculations and you arrive at a higher ratio, it typically means there’s more cash on hand. But if you get a lower ratio, it means your cash is tight, and a slowdown in sales could cause a cash flow issue.

How to Calculate Net Working Capital From Cash Flow

It’s very important that you learn how to calculate your business’s net working capital in order to run an active business day as well as estimate the impact of expenses on the company’s cash flow. The cash flow of a business automatically improves when the net working capital is reduced to.

In recent times, a lot of people tend to misplace the terms “working capital” and “cash flow.” However, the meaning and functions of these two terms differ. This is because working capital gives your business a picture of your company’s present financial state. Whereas cash flow shows you how much cash your organization can create over a particular period of time. 

Consequently, the amount of money your business earns in a year will differ from your monthly or quarterly cash flow, making your cash flow look more forward-looking. You will also agree that working capital gives you a solid picture of how soon your firm can pay urgent payments, whereas cash flow does not. However, in a situation where your company’s working capital is low but its cash flow is significant, it can create adequate cash if given enough time. Here are the steps you should take to calculate your net working capital from your cash flow.

Step 1

Determine the amount of a company’s current assets and liabilities on its most recent balance sheet and the balance sheet for the preceding accounting period.

Step 2

This step typically requires you to subtract the prior accounting period’s current liabilities from the current assets. 

Step 3

In the most recent accounting period, subtract the company’s current liabilities from its current assets. For example, if you subtract $250,000 from $350,000 in current assets, for the most recent accounting period, this equates to $100,000 in net working capital.

Step 4 

In order to calculate the change in net working capital, subtract the prior period’s net working capital from the most current period’s net working capital. A positive figure indicates that net working capital has increased, whereas a negative number indicates that it has decreased. Subtract $250,000 from the prior period’s net working capital and $100,000 from the most current period’s net working capital, which is a difference of $150,000 in net working capital. This typically means that the business’s cash flow from operations for the accounting period increased by $150,000.

How to Calculate Net Working Capital From an Income Statement

A positive net working capital typically suggests that a corporation can fund or support present operations while also investing in future activities as well as expansion possibilities. High net working capital isn’t always beneficial because it might mean the company has too much inventory or isn’t spending its cash at all. It is the assets and liabilities on a company’s balance sheet that are used to calculate net working capital estimates.

The income statement, balance sheet, and cash flow all make up the financial statement of a company. Therefore, cash, accounts receivable, inventories, and other assets are scheduled to be liquidated or converted into cash in less than a year. These are also all examples of a current asset list. Accounts payable, salaries, taxes payable, and the amount of long-term debt due in the next year are all examples of current obligations.

Determining the net working capital of a business from an income statement requires you to subtract current assets from current liabilities. For instance, if a corporation has $100,000 in current assets and $80,000 in current liabilities, its NWC is $20,000. Cash accounts receivable and inventory are examples of current assets. Accounts payable, short-term loan payments, and the current share of deferred revenue are all examples of current liabilities. You can typically use your business now as an example to understand how to calculate net working capital from an income statement.

Conclusion

The financial health of a business is the prime goal for most business owners. However, you can’t achieve this goal if you don’t properly know how to calculate the net working capital ratio, how to put it on the balance sheet and cash flow, or even how to get it from the income statement of your business. Your firm will undoubtedly benefit from applying the information in this post.

Read Also: Our Article On The Guide for Good Business Financial Performance

FAQs

What is an example of working capital?

In accounting, the working capital total is usually derived from the figures for current assets and current liabilities recorded on the balance sheet. For example, a company with $200,000 in current assets and $100,000 in current liabilities has a working capital of $100,000.

How do you calculate working capital of a new company?

To calculate working capital, subtract a company’s current liabilities from its current assets. A positive amount of working capital means a company can meet its short-term liabilities and continue its day-to-day operations

What are the 4 main componet of working capital?

The four main components of working capital are cash and cash equivalents. Accounts receivable (AR) Inventory.

  • Cash and Cash Equivalents
  • Accounts Receivable
  • Inventory
  • Accounts Payable
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