Need Help? Give us a call.
1 (800) 345-3452
The net working capital formula is equal to a business’s current assets minus current liabilities. A positive number shows that your company has enough cash and other liquid assets to cover short-term debts and expenses. A measure of your business’s liquidity, this number is important when raising money from investors or applying for a loan.
Although many business owners understand what working capital is, fewer have actually calculated how much they have. Knowing your level of working capital by understanding the net working capital formula is important if you’re trying to raise money, obtain a business loan, or partner up with another company for a project. These parties are more likely to work with you if your company’s liquidity is high, showing you’re able to manage your assets effectively and pay off your obligations.
Working capital includes cash and other liquid assets that a business has on hand to cover day-to-day business expenses, such as marketing, supplies, and payroll. Without sufficient working capital, your business can’t fulfill orders, pay staff, acquire customers, or carry out the hundreds of other tasks needed to grow a business. The working capital formula can help you figure this out.
Learn how the working capital formula works, see an example, and figure out how to interpret the result. You’ll also learn some proven strategies for improving your net working capital.
Working capital is the cash and other assets that you need to run your business efficiently on a day-to-day basis. Without sufficient working capital, you can’t pay suppliers and lenders, make payroll, market your business, or do the other things that you need to grow.
Small businesses and startups tend to have short lifecycles—you can tell pretty quickly if the business is going to succeed or fail. In fact, one-fifth of businesses fail in their first year, and nearly one-third fail by the second year. Insufficient capital to cover business expenses is one of the main reasons for business failure.
That’s why net working capital is an important indicator of your business’s financial health, both for yourself and for lenders, investors, and other third parties, too. The more working capital you have, the more liquid your company is in the short-term. You can pay off your business’s debts and obligations, plus have money left over to fuel growth and cover emergencies. On the other hand, a business that’s struggling to cover expenses might not be able to survive much longer.
→TL;DR (Too Long; Didn’t Read): Your business’s net amount of working capital indicates your liquidity levels. You’ll learn whether you have enough money to grow, while covering your business’s debts and other expenses.
Net working capital formula, also known as just working capital formula, measures the difference between what a business owns and owes in the short-term.
Here’s the basic formula for working capital:
Net Working Capital = Current Assets – Current Liabilities
Working capital is a balance sheet calculation, meaning that every number you need to calculate net working capital should appear on your most recent balance sheet. If you don’t know how to create a balance sheet, use our free balance sheet template.
Here’s an example of how to calculate net working capital, using a sample business called ABC Manufacturing. We start out with the company’s assets and liabilities for the coming year:
Total Current Assets = $1 million
Total Current Liabilities = $755,000
ABC Manufacturing has $245,000 of working capital. The company will have an estimated $245,000 left over at year’s end after paying all of their expenses and obligations. That means ABC is in a strong financial position for the coming year.
In this example, we calculated working capital for a one year period, but you can also go with a quarterly or monthly calculation. In that case, you’d include accounts receivables that will be paid within the quarter or month, and you’d include debt payments that are due within the quarter or month.
Working capital ratio is a formula that’s closely related to net working capital. Similar to the net working capital formula, this ratio compares your business’s assets and liabilities. Instead of subtracting these numbers, you divide them to get a ratio.
In our example above, you’d divide $1 million by $755,000 to get 1.3. That means the company has 1.3 times as many assets as liabilities. Ideally, you should strive for a working capital ratio between 1.2 and 2.0.
The working capital formula is pretty straightforward, but one common question is what to count as “current assets” and “current liabilities.” Business owners, accountants, and lenders sometimes have different preferences.
Current assets are cash and anything that you can easily convert to cash during the time period at issue. For example, you can relatively easily sell or liquidate inventory for cash, so that’s considered a current asset. Current assets usually include the following:
Current liabilities are any loans or expenses that you owe during the time period at issue. Current liabilities generally include the following:
Outlining your company’s assets and liabilities and calculating your working capital allows you to spot business risks. For instance, if your company has a lot of money tied up in real estate, equipment, and other fixed assets, you’ll have difficulty paying your bills when they are due. Ideally, a small business should strive for a balance of fixed assets and liquid assets.
→TL;DR: You can calculate working capital by subtracting current liabilities from current assets, for a period of one year, a quarter, or a month. Current assets are those that you can easily convert to cash. Current liabilities include short-term debt, accounts payable, and accrued expenses like wages.
As you might have already guessed, a positive amount of working capital is preferable to a negative number. And the more working capital you have on hand, the stronger your business’s immediate financial position is.
A positive net working capital means the following:
A negative net working capital means the opposite:
In most cases, you want to avoid negative working capital. However, for businesses with a rapid turnover of inventory, such as fast food chains and grocery stores, negative working capital isn’t necessarily a problem. These businesses transact with customers and bring in cash multiple times per day, so they don’t need to stockpile a large amount of working capital.
In addition, you want to avoid having too much working capital on hand. That can indicate that you’re sitting on too much cash, rather than investing profits back into the business. Also, the type of working capital that you have matters. Cash in the bank is more valuable than capital that’s tied up in unpaid invoices and unsold inventory.
→TL;DR: Having net positive working capital is ideal because this shows that you have enough cash and other liquid assets to cover your short-term liabilities. But businesses with a rapid turnover of inventory don’t need a lot of working capital.
The amount of working capital you have will impact your business’s ability to get a loan. The main thing that every business lender wants to know is whether you can pay back a loan, on time and in full. The answer to that question lies in your cash flow, and ultimately, your net working capital.
Matthew Nicolosi, who trains Fundera’s team of loan specialists, says:
Lenders check working capital by looking at your bank balances and assessing the history of deposits (credits or inflows of money) and debits (withdrawals or outflows of money). This shows how you manage cash on a short-term basis, and where the business is trending. Some lenders also ask for a balance sheet to assess net working capital.
Bank statements don’t show assets other than cash, and they don’t show liabilities, so they don’t provide a full picture of your business’s working capital. However, lenders will get some indication from bank balances of your business’s incoming and outgoing cash flow.
Short-term online lenders usually ask for 3 to 4 months of bank statements, and medium-term lenders usually require six months of bank statements. Banks and SBA lenders will ask for your current year’s balance sheet to do a more formal analysis of your working capital.
→TL;DR: Most lenders informally assess working capital by examining your business’s recent bank balances. Banks and SBA lenders also require your balance sheet to do a more in-depth analysis.
Net working capital is a financial snapshot of your business at a single moment in time. Just like any balance sheet calculation, net working capital can change dynamically over time, even from day to day.
When your current assets or liabilities change, so does your net working capital. For instance, a decline in the value of your inventory or an increase in the number of uncollectible invoices results in lower working capital. So does taking on debt.
Scott Orn, Chief Operating Officer at Kruze Consulting, says changes in working capital are more important than a single calculation:
Changes in working capital as a company grows are usually more important than the absolute number, since the change tells you about how the company’s cash will be used as the business grows.
In other words, working capital is a number you should monitor regularly and hopefully see an upward trend in as your business grows.
Here are some actionable ways to improve your net working capital:
The simplest way to improve working capital, but one that people often overlook, is to increase profits. You can accomplish this by upping your revenue or cutting costs. Cutting back on staffing or adapting your marketing spend could have the intended result.
To increase revenue, many small business owners borrow money. Paola Garcia, a small business advisor at Excelsior Growth Fund, says,
Working capital will only increase if you put more money into the business yourself or if you retain profits in the business. That’s where it may make sense to work with a lender to support your working capital strategy.
We know what you’re thinking: Won’t taking on debt lower my working capital? In the short-term, the interest you have to pay on the loan will decrease your working capital. However, if you can channel that debt to improve your business’s bottom line, then you’ll end up with more revenues and profits in the future.
Reducing your Accounts Receivable (AR) cycle turns money tied up in invoices into cash. This strengthens your working capital position. You can bill new customers with a Net 15 or Net 30 invoice instead of longer Net 60 or Net 90 terms. You can also encourage customers to pay you early with prompt payment discounts.
Another way to improve working capital is by carefully managing inventory levels. Although inventory is considered an asset in the working capital formula, lenders and suppliers prefer to see businesses that have more cash and less inventory that’s gathering dust on the shelves.
Make sure you order only the amount of inventory that you’ll be able to move off your shelves within a reasonable amount of time. Inventory management software can help you monitor inventory levels and set up automatic orders when inventory dips below a certain level.
Similar to unused inventory, unused long-term assets hurt your business’s short-term cash position. If you have, for example, equipment or a portion of your office space that you’re not using, sell or rent out those assets and convert them to cash.
Of course, you need to balance all of these strategies against other priorities for your business. You don’t want to sell off all your equipment, for instance, if it could potentially serve as collateral to help you secure a much-needed bank loan.
Lowering your debt payments increases your working capital. If you have an existing loan with a history of on-time payments, you might be able to refinance your business loan. Particularly if your credit score or business revenues have improved since initially getting your loan, you’re a good candidate for refinancing.
→TL;DR: Improving your working capital can be as simple as increasing profit margins and reducing debt payments and other costs. You can also shorten your AR cycle, manage inventory better, and convert long-term assets into current assets.
Working capital formula is an important measure of your business’s short-term liquidity. When calculating your net working capital, keep the following in mind:
Remember that working capital is a dynamic number. Sometimes, things outside of your control might cause your working capital to decline. But there are also actionable steps you can take to improve this number and grow your small business.