How to calculate net working capital

When it comes to calculating net working capital, you may write it off because it seems like just another item on an endless list of financial metrics to track. However, understanding and actively managing this figure is crucial for maintaining your company’s liquidity and operational efficiency.

Net working capital (NWC) is current assets minus current liabilities. Calculating NWC essentially measures a company's short-term financial health. 

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As the President of Brady CFO, a fractional CFO firm, we’ve worked with enough business owners and CEOs to know that running a company without a background in accounting and finance can feel overwhelming. The financial aspects of managing a business are both critical and complex, and without the proper guidance, it's all too easy to make missteps that could have been avoided. So, let’s dive into how to calculate NWC so you can confidently guide your company.

Understanding your net working capital

The goal of calculating net working capital is to determine how much excess current assets exist over current liabilities to run the business's day-to-day operations. NWC is not funds set aside for investment in machinery, equipment, land, business acquisitions, etc. Ultimately, it is the funds you use to cover payroll, pay vendor bills for supplies and services, etc. Think of net working capital as the funds you need to keep the lights on in your office to stay operational. The focus is primarily on the short term. 

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As I mentioned, net working capital is current assets minus current liabilities. So, you're probably wondering ... What are current assets and current liabilities?

Current assets

Current assets are very liquid assets. For example:

• Cash
• Accounts receivable
• Inventory
• Prepaid expenses
• Deposits in various savings accounts

These can all be liquidated pretty easily and converted to cash within a few months or less. For example, accounts receivable are amounts your customers owe you. Most businesses have payment terms with their customers ranging from 30-90 days. So, if you focus on collecting these outstanding amounts due, you should be able to convert all these outstanding invoices to cash. Therefore, you can liquidate accounts receivable quickly and quickly, making it a current asset.

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The same idea applies to inventory. Some inventory might be harder to sell, but ultimately, you could "fire sell" your inventory at discounted prices and convert it to cash within a few months or less.

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On the other hand, if you hold real estate as an asset in your business, it might take much longer to liquidate if the real estate market isn’t good. For this reason, real estate is not a current asset. Machinery and equipment are often not current assets, as they often take longer to sell.

Current liabilities

Current liabilities are all bills and debts due within the next year or less. This also consists of any debt due within the next 365 days on debt that has a much longer maturity date. For example, you might have debt that has monthly payments for the next 10 years, but in current liabilities, you would include the next 12 months of payments on that debt.

Calculating your net working capital

So, let's revisit net working capital, which is the excess of current assets minus current liabilities.

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        NWC = current assets - current liabilities

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The goal is for the total amount of liquid assets you have on hand to more than cover all of your debts and bills due within the next year or less.

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If the opposite is true (you have current liabilities greater than current assets), you effectively have negative net working capital, which is a dangerous position to be in. You do not want to operate with negative net working capital, which must be resolved ASAP. Otherwise, you risk not covering payroll and are at serious risk of potential bankruptcy.

Managing your net working capital

Net working capital should be positive. You should have more current assets than current liabilities. However, you also want to avoid having too much net working capital. While we have seen savings interest rates climb recently, your business should be able to earn a much higher ROI on cash than keeping that cash in a savings account. 

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If you have current assets above the amount you need to maintain a positive NWC, you should reinvest them in your business. This could involve upgrading equipment, exploring potential acquisitions, or embarking on new growth initiatives — all of which can propel your business forward. Other options include paying down long-term debt or paying yourself a distribution as a business owner. 

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Maintaining healthy levels of NWC gives you a better chance of obtaining financing for future projects. In our experience at Brady CFO, even some more aggressive banks want to see that a business maintains a fixed amount of net working capital on its balance sheet at each EOY (depending on your business size).

Fixing your net working capital

At Brady CFO, we’ve seen issues with companies not maintaining healthy net working capital. The solution to fixing this depends on the specifics of the situation. One option is to focus on the short term by refinancing debt due in the next year into longer-term debt. By doing this, our clients effectively reduce current liabilities to bring balance back to their business. 

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We recently converted a $2.5 million outstanding credit line balance due in the next 365 days into a 7-year fixed note at 9.5% APR. This resulted in $490k of principal + interest due within the next year instead of $2.5 million. We effectively removed $2,010,000 of current liabilities from the balance sheet. This helped put the business into a much healthier NWC position, which made the bank feel more comfortable. 

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Remember, a positive net working capital indicates your company has enough liquid assets to cover its short-term liabilities. This is a good sign of financial stability. On the other hand, a negative net working capital suggests your company might struggle to meet its obligations, signaling potential financial difficulties. Understanding how to calculate and manage net working capital effectively is vital for maintaining the operational liquidity and overall financial health of your business.

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