Working capital – or net working capital (NWC) – is a measure of a company’s liquidity.
It’s the difference between a company’s financial assets (anything it owns or is owed) and liabilities (anything it owes).
So, a firm can have either positive working capital (suggesting it can afford to pay its debts and invest in its growth) or negative working capital (indicating it may be struggling).
Calculating a firm’s working capital is simple. Subtract its current liabilities from its assets.
The formula is as follows:
Current assets – current liabilities = net working capital (NWC)
The result can be either a positive or negative number. This figure is used to determine a business’s financial risk profile.
However, there is more to working capital than this simple explanation.
When calculating NWC, it’s important to consider the company’s current assets. These may include:
Once the total value of these assets is calculated, the company must subtract the cost of its liabilities. This is everything the company owes and may include:
The resulting sum is the business's net working capital (NWC).
ABC Ltd wants to see how much money it has available to invest in growth so it decides to calculate its net working capital.
Firstly, ABC Ltd totals the value of its assets such as property and product stock, plus everything it is owed such as unpaid invoices. ABC calculates that these assets total $1 million (USD).
Next, ABC Ltd adds up its liabilities, including debts, overheads, operating expenses and any invoices it has to pay. ABC Ltd works this out to be $750 000 (USD).
Finally, ABC Ltd subtracts the value of its liabilities from the value of its assets:
$1 million (USD) – £750 000 (USD) = $250 000 (USD)
ABC Ltd calculates that it has $250 000 (USD) in positive working capital. Therefore, it can confidently and comfortably afford its outgoings and invest in growth.
Working capital is important for the following reasons:
Additional capital would benefit every business but some companies in specific industries may need fast access to more working capital.
These situations could include the following:
A working capital cycle is the time it takes a business to turn its assets and liabilities into cash.
Working capital cycles are different for each company. They depend on the terms of both accounts receivable and accounts payable, and on how long the company holds stock before selling it.
Many companies prefer shorter working capital cycles because they allow easier access to liquid capital to invest in the company. Longer working capital cycles often leave companies operating for months with valuable cash tied up.
It’s difficult to achieve the ideal working capital cycle, particularly if a company sells and ships goods internationally. International Buyers often demand deferred payment terms (sometimes up to 120 days) which can leave Suppliers (especially those in emerging markets) with very little income until invoices are paid.
The traditional working capital formula is straightforward. However, there are some other calculations which can give companies a better idea of how to cover their costs.
This is a formula that shows the proportion of assets against liabilities. Instead of subtracting liabilities from assets, the company should divide the value of assets by the value of liabilities. If the working capital ratio is 1 or lower, that could suggest the company may struggle to cover costs, while ratios of 2 or higher suggest the company is performing well.
Some companies prefer to calculate NWC using an adjusted formula. It’s the same formula as the standard NWC calculation but liquid capital is not included in assets. This then shows whether a company’s short-term assets and liabilities are reasonable and sufficient.
Companies might want to increase NWC to fund new opportunities, grow into new markets, serve new customer sectors or avoid bad debt.
Increasing working capital can be achieved by:
If you are interested in learning more about invoice factoring, Stenn has a dedicated FAQ section where you can find more information about our invoice financing services. We also provide videos which explain the company and the financing process in detail.
About the Authors
This article is authored by the Stenn research team and is part of our educational series.
Stenn is the largest and fastest-growing online platform for financing small and medium-sized businesses engaged in international trade. It is based in London, provides financing services in 74 countries and is backed by financial giants like HSBC, Barclays, Natixis and many others.
Stenn provides liquid cash to SMEs within the global financial system. On stenn.com you can apply online for financing and trade credit protection from $10 000 to $10 million (USD). Only two documents are required. No collateral is needed and funds are transferred within 48 hours of approval.
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