Net Working Capital is the measure of cash or liquid means a company has available for running its day-to-day operations. It represents an essential element for operating a business. By ascertaining Working Capital a company determines if it can meet its short-term financial obligations. To calculate Net Working Capital simply take Current Assets and subtract Current Liabilities. For example, if your Current Assets total $40,000 and Current Liabilities are $25,000, your Net Working Capital will be $15,000.
Current Assets and Current Liabilities
Current Assets are either cash or any assets that can be immediately sold for cash (e.g., inventory, receivables). Current Liabilities are anything that costs you money (e.g. bills, taxes, debt).
Is payment credit considered an asset or a liability? It depends on who is extending the credit. If suppliers sell to you on credit – it’s considered a liability. If you extend credit to your customers, so they can buy from you, it’s considered an asset, even if you only expect payment in another month.
Is it worthwhile to extend credit to customers? This also depends. If you allow customers to pay on credit (vs. only upfront), will you gain more customers and/or business? How much? Will this gain translate into profit greater or less than your total financing cost? If it’s more, then it’s worthwhile to sell on credit.
How Much Working Capital Do You Need?
How much Working Capital does a company need? Since Working Capital is required to fund the business’ day to day operations, you never want too little. At the same time, however, very low or even negative Net Working Capital might not be ideal for your business either. As mentioned above, you might be able to gain more business by extending credit to your customers. A helpful indicator you can use to assess your working capital condition is called the Working Capital ratio. You can calculate this ratio by dividing Current Assets by Current Liabilities.
The ideal ratio is around 2. If it falls below 2, it could be a sign of financial problems and you may be unable to pay off your Current Liabilities. If it’s above 2 it could mean a poor or inefficient use of capital. In our example, the ratio would be $40,000/$25,000 = 1.6, which is slightly low.
Optimizing Working Capital
There are many ways to optimize Net Working Capital:
How can you improve payables to optimize your working capital? For starters, contact suppliers and vendors and ask for better payment terms – perhaps the option to pay over a longer period of time, to pay later, buy in volume, or request a discounted price for up-front payment.
Collecting accounts receivables is vital to maintaining working capital. To ensure money keeps coming in, make sure that the payment terms are clear. After sending an invoice, consider calling the customer to verify that it was received. Other options include offering discounts for early payments or fines for late ones. If cash flow is stagnant, perhaps financing can fill the gap.
Monitor inventory closely and optimize inventory days (amount of time you store inventory between being bought and sold). Basically you want to avoid both under-stocking and over-stocking. To do this many companies use the Just-In-Time (J.I.T.) inventory formula because it’s cost-effective and reduces inventory space, stock-holdings and the chances of damaged stock.
Pay off short-term loans when they become mature. In addition, never purchase fixed assets with short-term loans since you can’t convert them quickly back into cash if you need to pay off the loans as this could negatively affect Working Capital.
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