Net working capital measures a company’s financial health by subtracting current liabilities from current assets. A positive ratio indicates the ability to pay creditors and make business improvements, while a negative ratio indicates financial difficulties. It can also indicate a company’s efficiency and trends over time.
Net working capital measures a company’s liquidity, efficiency, and overall financial health at the time it is calculated. To calculate this amount, also known as the working capital ratio, a company’s current liabilities are subtracted from its current assets. A positive ratio indicates the ability to pay creditors and make business improvements, while a negative ratio indicates financial difficulties. Comparing the net amounts of working capital over different time periods is helpful in determining areas where a company is having success with its cash management and areas where improvement is needed.
Simply making a profit does not guarantee the financial success of an individual business, especially if that profit does not translate into capital that can be used to improve the business. The net working capital measurement is a good way to measure a company’s cash management and, more importantly, its ability to operate without falling behind on its financial obligations. The working capital ratio is determined by taking all of the company’s various assets, which can come in the form of cash, stock, accounts receivable, or inventory, and subtracting its liabilities, which generally take the form of accounts payable.
For example, imagine a company that has a total of $500 in US dollars (USD) in assets and $250 in liabilities. In that situation, subtracting the $250 from the $500 would leave $250 of net working capital. This essentially means that if the company were forced to immediately pay all of its accounts payable, it would still have $250 remaining in the bank.
This ratio is similar to the current ratio, which is calculated by dividing a company’s assets by liabilities. For example, using the above numbers, that company’s current ratio would be 2.00, which is the result of dividing the $500 USD by $250 USD. In both cases, a positive relationship indicates that a company has the ability to pay its debts and make improvements, while a negative relationship is problematic and means that the company needs to improve its financial health.
Net working capital can also be a good indicator of a company’s efficiency. A company that has strong sales numbers and still suffers with low amounts of capital may be inefficient at collecting payments or capitalizing on inventory. By measuring working capital ratios over several different time periods, trends can be revealed that show whether a company’s capital is strong and stable over the long term or whether some sort of correction needs to be made to reverse a decline.
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