Sarah has taught QuickBooks classes, has a Bachelor of Science degree in Accounting, and is a licensed CPA.
What Is Net Working Capital?
The success or failure of a business is heavily dependent on that business's ability to use its assets effectively. An asset is an item that a business owns, such as cash in a bank account, amounts due from customers, and equipment. When a business uses its assets effectively, it is able to produce income to further increase its assets and pay its liabilities. A liability is an item that a business owes, such as an outstanding bill from a vendor or a mortgage or loan. A business can determine its ability to pay its liabilities as they become due by calculating net working capital.
Net working capital is a financial measure that determines if a business has enough liquid assets to pay its bills that are due in one year or less. Assets are liquid if they can quickly be converted to cash. Examples include cash, amounts due from customers, short-term investments and marketable securities, and inventory.
Calculating Net Working Capital
Net working capital is calculated by subtracting total current liabilities from total current assets. Assets and liabilities are considered current if they are expected to be used or paid within one year. Current assets include all of the liquid assets discussed previously. Current liabilities include outstanding bills, payments on mortgages and loans due in the next year, and amounts due to others that are not yet payable, such as wages and interest.
Net working capital is presented as a dollar amount and can be positive or negative. A positive result means that there will be liquid assets remaining after all current liabilities are paid and that assets are being used effectively. On the other hand, a negative result means that there are not currently enough liquid assets to pay all of the current liabilities and that a business may be headed towards bankruptcy.
Now let's look at a couple of examples.
Nelson & Associates is a small, family-owned business. William Nelson has recently taken over the business from his father and is concerned there will not be enough funds to run the business for the next year. He has come to you to calculate the business's net working capital. The business has $100,000 in the bank, $200,000 due from customers, and $50,000 of inventory. The business owes $225,000 to vendors and has a $500,000 mortgage, of which $50,000 is due in the next year.
The business's net working capital ratio would be calculated like this:
100,000 cash + 200,000 due from customers + 50,000 inventory = 350,000 current assets
225,000 due to vendors + 50,000 current portion of mortgage = 275,000 current liabilities
350,000 current assets - 275,000 current liabilities = 75,000 net working capital
After performing the calculation, you will be able to tell William that the business will have $75,000 in liquid assets remaining after the current liabilities are paid.
Now assume all of the same facts from the last example, but that Nelson & Associates also had a $100,000 short-term loan from a bank due in six months. Current liabilities would increase from $275,000 to $375,000, and net working capital would be calculated as follows:
350,000 current assets - 375,000 current liabilities = (-25,000) net working capital
In this example, after performing the calculation, you will be able to tell William that the business will need to come up with an additional $25,000 in liquid assets to ensure that all liabilities are paid.
Let's review. Net working capital is a financial measure that determines if a business has enough liquid assets to pay its bills that are due in one year or less. Net working capital is calculated by subtracting a business's current liabilities from its current assets. Assets are what a business owns and are liquid, or current, if they can quickly be converted to cash and will be used within one year. Liabilities are what a business owes and are current if they must be paid within one year. When the calculation result is positive, a business has more than enough liquid assets to pay its bills and is using its assets effectively. When the calculation is negative, a business does not have enough liquid assets to pay its bills and may be in danger of bankruptcy.
Key Words & Definitions
|Asset||an item that a business owns, like cash in bank accounts, customer payments, and equipment|
|Liability||an item that a business owes such as outstanding bills, mortgages or loans|
|Liquid||assets that can quickly be converted to cash|
|Current||another term for liquid|
Determine how well prepared you are to accomplish these goals after studying the lesson on net working capital:
- Write the definition of 'net working capital' word for word
- Calculate for net working capital by working through some examples
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