What Is the Net Working Capital Formula

The net working capital ratio measures a business's ability to pay off its current liabilities with its current assets. This ratio provides business owners with an idea of their business's liquidity, and helps them determine its overall financial health.

To gain a better understanding of what the net working capital ratio is, we'll explore examples of the ratio at work, how to calculate it, and what it means for your business.

Definition and Examples of Net Working Capital

A net working capital ratio gives business owners a general idea of their business's liquidity by showing how effective it is at paying off its current liabilities (outstanding short-term debt) with its current assets. The net working capital ratio's numerator and denominator come from a business's balance sheet, and you can find them in the formula below:

• Alternate name: Current ratio

Here's an example: If a business has $1,000 in cash, $2,000 in accounts receivables, $2,000 in inventory, and $2,500 in current liabilities, what is its net working capital ratio?

Net Working Capital Ratio = Current Assets / Current Liabilities

= Cash + Accounts Receivables + Inventory / Current Liabilities

= $1,000 + $2,000 + $2,000/$2,500

= 2.0

This means the business can cover its current liabilities twice over with its current asset base.

How the Net Working Capital Ratio Works

The net working capital ratio is sometimes defined incorrectly. You may see it defined as current assets minus current liabilities. That equation is actually used to determine working capital, not the net working capital ratio.

Working capital refers to the difference between current assets and current liabilities, so this equation involves subtraction. The net working capital ratio, meanwhile, is a comparison of the two terms and involves dividing them.

Current assets refer to those assets that mature within one year. Current liabilities refer to those debts that the business must pay within one year. The desirable situation for the business is to be able to pay its current liabilities with its current assets without having to raise new financing.

Current assets typically include cash, marketable securities, accounts receivable, inventory, and prepaid expenses. Current liabilities include accruals, accounts payable, and loans payable.

Extended Example of Net Working Capital Ratio

Here is an extension of the example used previously:

If this business also has $1,000 in marketable securities, and the current liabilities include $3,000 in loans payable, what is the net working capital ratio?

Net Working Capital Ratio = Current Assets / Current Liabilities

= Cash + Accounts Receivable + Inventory + Marketable Securities / Current Liabilities + Loans Payable

= $1,000 + $2,000 + $2,000 + $1,000/$2,500 + $3,000

= $6,000/$5,500

= 1.09 Times

This means the business can cover its current liabilities—but just barely—at 1.09 times.

As mentioned above, the net working capital ratio is a measure of a firm's liquidity or how quickly it can convert its assets to cash. In the extended example provided, you can see that if the business has fewer credit customers (accounts receivable) than anticipated, or if it has less inventory, cash, or marketable securities than expected, the net working capital ratio can fall below 1.0. If that happens, then the business would have to raise financing to pay off even its short-term debt or current liabilities.

In reality, you want to compare ratios across different time periods of data to see if the net working capital ratio is rising or falling. You can also compare ratios to those of other businesses in the same industry.

A good rule of thumb is that a net working capital ratio of 1.5 to 2.0 is considered optimal and shows your business is better able to pay off its current liabilities.

Key Takeaways

• The net working capital ratio measures the liquidity of a business by determining its ability to repay its current liabilities with its current assets.
• Working capital is the difference between current assets and current liabilities, while the net working capital calculation compares current assets and current liabilities.
• An optimal net working capital ratio is 1.5 to 2.0, but that can depend on the business's industry.
• To adequately interpret a financial ratio, a business should have comparative data from previous time periods of operation or from its industry.

What Is the Net Working Capital Formula

Source: https://www.thebalance.com/what-is-net-working-capital-ratio-5194672

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