calculate net working capital

What is Net Working Capital? Definition, Formula, Importance, and How to Calculate It

July 21, 2022 • 2789 views
Author: PoonawallaFincorp Category: Business Loan

Working capital is essential for any business. This is because businesses need money to meet their short-term expenses. Some of these expenses include paying for raw materials, compensating employees, and paying for utilities and rent. 

If your business doesn’t have enough working capital, you can opt for a Working Capital Loan in India. It is a type of Business Loan that is specifically meant to facilitate the working capital requirements of a business. 

If you’re not sure how to calculate your business’s net working capital to know its liquidity, we’ve got you covered. 

What is Net Working Capital?

We’ve all heard about working capital, but only a few know what is net working capital. Let us first understand what net working capital means. It helps in determining or measuring the short-term liquidity of a firm. Net working capital is also used to get an idea about a business’s ability to optimally utilize available resources efficiently. So, net working capital means the difference between the current assets and current liabilities of a business.

A positive net working capital indicates that a business has enough money to meet its short-term expenses. It acts as an indicator of the solvency of a business. If a business has negative working capital, it will need to raise money through funding. This can also be done by applying for financial support like Business Loans to meet various operational expenses.  

A good option to stay solvent is to avail of a Working Capital Loan. This is especially important if you already have or foresee a possibility of negative net working capital in the future.

A Working Capital Loan in India is tailor-made to meet the working capital requirements of your business. You do not have to provide any security or collateral to avail of such a loan. Furthermore, you can take advantage of flexible loan repayment tenures which suit your business plan. 

Net Working Capital Example

If you need to pay Rs.30 Lakh every year to your employees and you have an annual debt of Rs.15 Lakh, then your current liabilities are Rs.45 Lakh (Rs.30 Lakh + Rs.15 Lakh).  

How to Calculate Net Working Capital?   

As the name suggests, the net working capital formula is used to calculate net working capital.
Your net working capital is your current assets minus your current liabilities. Hence, from the above example, your net working capital would be as per the net working capital formula:

Rs.84 Lakh (current assets) – Rs.45 Lakh (current liabilities) = Rs.39 Lakh (net working capital) 

So, net working capital is equal to:

Net Working Capital Formula = Current Asset– Current Liabilities

Net working capital ratio, on the other hand, refers to the proportion of a business’s short-term cash (net) to its assets. The net working capital ratio formula is as follows:

Net Working Capital Ratio = (Current assets - Current liabilities) ÷ Total Assets

Also Read: An Overview of Invoice Factoring in Small Business Financing

What are Current Assets?  

Items on your balance sheet that can be converted into cash within a year are known as current assets. Cash and cash equivalents (such as money market funds, commercial paper, treasury bills, etc.) are examples of current assets. 
Essentially, current assets can be used to pay for your business’s operating expenditures. 

1. Cash and Cash Equivalent

This includes any liquefiable investments of the business. For example, if a business has invested in stocks of a publicly traded company, then it counts as a cash equivalent.  

2. Inventory

This includes all the goods that a business owns that have not been sold yet. It also includes any raw materials and partially assembled goods. 

3. Accounts receivable

This entails all the money that is due to come into the business. For example, your inventory has been sold on credit and the dues are going to be repaid within the year. In this case, that counts as accounts receivable.  

Suppose your business has cash worth Rs.24 Lakh and inventory worth Rs.60 Lakh. This means that you have current assets worth Rs.84 Lakh (Rs.24 Lakh + Rs.60 Lakh).

What are Current Liabilities?  

Current liabilities are those items on your balance sheet that need to be paid for within one year. Some examples of current liabilities include debt payable, payable accounts, employee salaries, and so on.  
Essentially, current liabilities are your short-term financial obligations.  

1. Payable Salaries

Usually this is the biggest current liability of a small to medium-sized business. The wages that need to be paid to employees within one year are included as current liabilities. 

2. Accounts Payable

This refers to any money that needs to be paid to vendors, utility services, rent, taxes, and so on. 

3. Debts Payable

This includes any debt repayment that needs to be made within the space of one year. If you have long-term debt but some instalments must be repaid within the year, that counts as a current liability.  

If you need to pay Rs.30 Lakhs every year to your employees and you have an annual debt of Rs.15 Lakhs, then your current liabilities are Rs.45 Lakhs (Rs.30 Lakhs + Rs.15 Lakhs).  

Also Read: How Business Loans Take Your Business Higher?

How to Increase Net Working Capital  

If you’re looking to increase your net working capital, then these tips might help.  

1. Unload Long-Term Assets for Cash  

Long-term assets do not count as current assets. This is because the value of these assets is spread out over a period of more than one year. 

You may have long-term assets that are not being used. Suppose you have machinery that isn’t being used but needs to be repaired. You can have it repaired and then sell it for cash. This cash will then count towards your current assets, increasing your liquidity. 

2. Refinance Your Debt  

Debt can account for a large portion of your current liabilities. A business may have lots of short-term debt such as credit card payments and lines of credit. It is possible to refinance such debt and turn them into longer-term debt. For example, you can get a Business Loan to repay your short-term debt.   

Refinancing can help to ensure that you have fewer debt repayments that are due within one year. Hence, it can help you increase the liquidity of your business.  

3. Sell Excess Inventory  

A business may find itself in a position where it has a lot of excess inventory. You can review your inventory to find items that can be sold in the short term. Even though inventory counts as a current asset, it is still not as liquid as cash. This is because selling inventory can be more difficult than spending cash.  

So, if you have excess inventory, then selling such inventory for a discount can help you meet short-term financial requirements.  

Wrapping Up 

Essentially, net working capital measures the ability of a company to meet its short-term financial obligations. If a company has excess working capital, then it means that it can not only meet its finances but also invest in its growth. However, extra working capital can be an indicator of excess inventory or not investing excess cash properly. 

If your net working capital is falling short, consider taking out a flexible Working Capital Loan in India to meet your obligations.

Net Working Capital - FAQs

  • What does net working capital mean? 

Net working capital is the amount you have calculated as the difference between the current assets and current liabilities of a business.

  • How do you calculate the net working capital ratio? 

Net working capital ratio is calculated as per the following formula:

Net Working Capital Ratio = (Current assets - Current liabilities) ÷ Total Assets

  • Why calculating net working capital is important? 

Calculating net working capital is important to ensure that your business always has adequate capital to run smoothly.

  • Can a company improve net working capital? 

Some of the best ways a company can follow to improve its net working capital are:

  • Pay off debts quickly
  • Prioritise inventory management
  • Evaluate your expenses

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