Understanding net working capital

Net working capital (also called working capital or NWC) is an essential financial metric used to help small business owners determine the liquid cash they have on hand to cover short-term financial obligations. Working capital is calculated by subtracting current liabilities from current assets, giving business owners a vital snapshot of the company’s liquidity and short-term financial agility. 

A positive net working capital indicates healthy cash flow and good management of accounts payable and accounts receivable. A negative change in working capital (or a negative number) may indicate an issue with accounting or inventory management. Net working capital is also essential for calculating free cash flow, which is used to reconcile net income through adjustments for non-cash expenditures.

Key takeaways

• Net working capital is a financial metric that shows a business’s ability to cover short-term expenses, also known as the company’s liquidity.
• Net working capital is calculated using two components: current assets minus current liabilities.
• Current assets refer to any economic benefits your company will receive within the next 12 months, such as short-term investments, cash, and accounts receivable.
• Current liabilities refer to any financial liabilities (e.g., debts) that you must meet within the next 12 months.
• If your working capital calculations equal a negative number, it means your current liabilities exceed your current assets, and you will need to find ways to get additional funding or save more money.
• Negative changes to net working capital may indicate issues with accounts payable, accounts receivable, or inventory management.
• Net working capital is essential for calculating free cash flow, which is the amount of accessible cash your business has to reinvest in its growth or distribute to shareholders.
• Accounting software can help small business owners track and maintain their net working capital.

Table of contents

• Introduction to net working capital
• Components of net working capital
• How to calculate net working capital
• Cash flow management
• Negative working capital
• Impact of negative change
• Free cash flow
• Effortlessly track net working capital with FreshBooks

Introduction to net working capital

Net working capital, sometimes called NWC or simply working capital, is a financial metric used by businesses to gain a quick snapshot of their current assets versus their current liabilities. In other words, working capital provides a view of how your company’s liquid assets and how much is available to cover short-term costs.

A solid understanding of your working capital is instrumental for business success. By tracking this figure, you can benchmark your business against competitors, calculate your business’s efficiency rates, and plan your future growth according to your actual financial flexibility. Knowing how net working capital is tracked and calculated also allows you to maintain your short-term financial health through optimized cash flow and agility, ensuring you can pay for unexpected and short-term obligations as they come up. 

In this guide, we’ll be explaining everything you need to know about net working capital, including current assets and current liabilities, how to calculate it using the net working capital formula, management tips, and how accounting software can help. Let’s take a look!

Components of net working capital

The two primary elements of net working capital are your current assets (assets that can be converted to cash within 12 months) and current liabilities (debts which must be paid within 12 months), both of which are listed on your balance sheet. Working capital is primarily focused on your most liquid (available for use) assets and immediate debts, making it more of a short-term look than other financial statements and metrics.

Current assets

Current assets refer to payments or other economic benefits that your business will receive within the next 12 months. Typical current assets that make up working capital include:

• Cash & equivalents: This is all the money your company has on hand, plus cash equivalents like foreign investments or low-risk, short-term investments.
• Inventory: This type of current asset refers to all of your unsold goods, including works-in-progress, raw materials, or finished goods that have yet to be sold.
• Accounts receivable: This is any money you are owed for items or services sold on credit, excluding the allowance you set for doubtful payments.
• Notes receivable: These are claims to cash for agreements other than sales, and are typically documented with a signed agreement.
• Prepaid expenses: This asset is the value of any expenses you’ve paid in advance.

Current liabilities

Your current liabilities are all debts and short-term obligations that your business owes or will owe within the next 12 months. These liabilities often include:

• Accounts payable: Any outstanding invoices that you must pay to vendors for supplies, materials, rent, taxes, or other operating costs.
• Wages payable: This liability refers to all staff wages and salaries that are yet to be paid.
• Accrued tax payable: This liability covers your tax obligations to government entities, including accruals.
• Current portion of long-term debt: These are short-term debt payments that are due on a longer-term debt.
• Dividends payable: This is any dividend payment to shareholders that has already been authorized.
• Unearned revenue: This refers to any funds you receive before completing a job, and is considered a liability because it must be returned if your company fails to complete the project.

How to calculate net working capital

Calculating net working capital to determine your company’s liquidity is quite straightforward — all it comes down to is subtracting your current liabilities from your current assets using the net working capital formula:

Net Working Capital = Current Assets – Current Liabilities

By using this formula and the current asset and liability information you get from your balance sheet, you can easily determine your business’s available capital, which will help you determine your company’s ability to cover short-term obligations and help you make future financial decisions for your business.

Cash flow management

Without proper management of your cash flow (including regularly generating cash flow statements), it will be extremely difficult to maintain a healthy, positive net working capital. When cash flow is high, businesses have the ability to cover unexpected expenses, make bolder decisions, and generally be more flexible and agile when it comes to managing company finances. A positive net working capital essentially means that the company has enough liquid current assets on hand to cover its short-term obligations, meaning they’re far more able to seize opportunities as they arise.

Business owners can improve their cash flow (and working capital management) in a few ways, such as prioritizing proper management of their accounts receivable, optimizing inventory levels to free up working capital, or refinancing short-term debt to get better repayment terms. By practicing these strategies, you’ll find you have more working capital at your disposal, helping you avoid financial stress and enjoy more sustainable growth of your company.

Negative working capital

You hope to see a positive working capital after performing your net working capital calculations, indicating that your company’s current assets exceed its liabilities. However, it’s possible that you’ll instead get a negative number, known as negative working capital. This occurs when a company’s current liabilities exceed its current assets. Essentially, this means that the company doesn’t have the current assets needed to pay its short-term debts and will need to seek additional funding through another method, such as finding investors, lowering labor costs, or finding ways to save on production.

Companies with consistently negative working capital will struggle to invest in growth initiatives and may need to spend a few months or years becoming cash flow positive before they can expand their services or area of operation.

Impact of negative change

Beyond finding yourself unable to pay for short-term debt, a negative change in working capital can have other effects on your business. Naturally, a reduced working capital indicates potential cash flow problems, which spells financial stress for business owners. Companies with a negative change in working capital will need to find ways to increase it, either by seeking additional funding or reducing their short-term financial obligations.

Negative changes to your net working capital can also be a sign of other problems within the business. It may suggest inefficient management of your accounts receivable, meaning that your business isn’t collecting payments from clients as regularly or consistently as it should be. It could also point to mismanagement of your inventory or accounts payable, as both of these can greatly affect your day-to-day working capital. 

Just like knowing the importance of a positive working capital, understanding the potential effects of a lowering or negative NWC is essential for smart business practices. A strong knowledge of negative changes to working capital will help you to better evaluate your company’s ability to cover expenses, its financial health, and its overall growth prospects, allowing you to fund operations for your business.

Free cash flow

Free cash flow (FCF) is a related but separate concept from net working capital. Free cash flow is the amount of liquid, accessible cash that a company has available to invest in its growth or distribute to shareholders, and is another indicator of your business’s short-term financial health. FCF is used to reconcile net income by adjusting for non-cash expenditures, changes to net working capital, and any capital expenditures your company makes.

Changes in working capital increase or decrease the amount of cash your business has available, which directly impacts your company’s net working capital. In general, an understanding of FCF and its connection to working capital can provide valuable financial insights.

For instance, a decrease in accounts payable may indicate that your vendors need to be paid more quickly. An increase in your accounts receivable might mean that your business isn’t efficiently collecting payments from customers, harming your cash flow. An increase in your inventory, meanwhile, could indicate that you’re overproducing and underselling. By including working capital and free cash flow in your business analysis, you’ll get deeper insights into the day-to-day financial realities of your company than if you were to simply use your income statement.

Effortlessly track net working capital with FreshBooks

Naturally, a business must have some liquid cash on hand to ensure it can meet all its financial obligations and short-term debts as they come up. By prioritizing a healthy, positive working capital, you’ll be able to avoid late payment fees and penalties, seize opportunities for growth as they arise, and grow your business to its full potential.

Of course, working capital management and analytics can be a tricky, time-consuming task, especially for small business owners spending long hours on the business itself. That’s where a cloud-based, easy-to-use accounting software like FreshBooks comes in. With useful features like cash flow tracking, expense and income statement reporting, accounting of current assets and current liabilities, invoicing tools, payment reminders, and other tools to help you get a picture of your short-term assets and liabilities, FreshBooks is here to make financial management and working capital simpler for small and home-based businesses.

If you’re ready to get on top of your cash flow and ensure a steady net working capital for your small business, while also simplifying the basics of day-to-day finances, FreshBooks is here to help. To learn how this platform can empower business owners like you, try FreshBooks for free today!

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