Net capital is a company’s net worth calculated by subtracting liabilities from assets. Inventory is often deducted as it may not be easily sold for full value. Net capital is used to determine a company’s ability to meet short-term financial obligations and is measured by financial ratios such as the current and quick ratios.
Net capital is the net worth of an organization, commonly calculated by total assets minus total liabilities. A variation on this formula is to deduct assets that are not easily converted to cash, such as promissory notes or inventory. This eliminates assets for which the company cannot achieve full value when it sells them during business liquidation. Inventory is a common deduction from net worth because a business may have specific items that have a small niche market for these items.
A secondary definition of net worth is found in the financial services industry. Companies that act as brokers or dealers in security investments must keep specific liquid capital on hand as per government requirements. For example, a ratio might be 10 to one, indicating that for every $10 US Dollars (USD) in debt, the brokerage must have $1 USD of liquid assets. Liquid assets are typically cash and cash equivalents, such as accounts receivable, short-term investments, notes receivable, or other items that the business can quickly sell to raise cash. Some countries may consider precious such as gold and silver as cash equivalents.
Business stakeholders use net capital to determine how well the business can meet short-term financial obligations. The liability part of the net worth formula is accounts payable and other short-term obligations owed by the company to suppliers. These obligations will quickly affect the solvency of a company if they are not paid. Therefore, the company must have the cash to cover these obligations. Two financial ratios that measure a company’s liquidity using net capital information are the current and quick ratios.
The current ratio is current assets divided by current liabilities. For example, a company with $750,000 in current assets and $250,000 in current liabilities has a current ratio of three. Typically, a current ratio of less than one means that a company is having significant trouble meeting its obligations in the near term. Another view means that the company has $3 in current assets for every $1 in current liabilities.
The quick ratio removes inventory from the current ratio formula. As noted above, companies may not be able to sell inventory in a short period of time to pay current liabilities. For example, a company has $750,000 in current assets, of which $250,000 is inventory. With $250,000 in current liabilities, the company’s quick ratio is two, meaning the company now has $2 in cash and cash equivalents to pay for every $1 in current liabilities. These rations are quite common when reviewing a company’s net capital position.
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