Small business owners have a lot on their plates. Between managing employees, marketing their business, and ensuring legal compliance, they also manage the growth and direction of their company.
In order to do that effectively, they need to have a good idea of their company’s health.
Perhaps the best metric of business health is net working capital. While other metrics can be subjective and nebulous, net working capital gives a clear, realistic look at how well your business is working—or isn’t.
If you want to know how to calculate net working capital for your business, read on!
What Is Working Capital?
Some business owners look at their bank account, see a large number, and think they’re doing well. But that number doesn’t tell the whole story.
Your bank balance is only one part of your cashflow. After all, having $100,000 in your checking account doesn’t matter much if you have $150,000 in expenses coming out.
Simply put, working capital is the amount of money that a company has to fund day-to-day expenses. By knowing your working capital, you have a picture of how able your company is to take new opportunities and make new investments.
Formula to Calculate Net Working Capital
The most basic working capital equation is as follows:
Net Working Capital = (Current Assets) – (Current Liabilities)
Let’s talk a bit about what those terms mean.
In basic terms, assets refer to the money that you have. This includes bank balances, inventory, and accounts payable.
The term “current assets” refers to all assets that can be converted to cash within a year.
This includes the three previous assets as well as stock options, securities, and pre-paid liabilities. It does not include things like real estate, copyrights, machinery or other items that will probably not be sold this fiscal year.
While assets are the money you have, liabilities are the money you owe.
This includes the sum of your business loans, accounts payable to suppliers, and taxes.
When calculating net working capital, you will only concern yourself with the liabilities due within the next year.
Working Capital Ratios
In addition to your base working capital, it’s important to know your working capital ratio.
You can find your working capital ratio with the following equation
Working Capital Ratio = Current Assets ÷ Current Liabilities
This ratio can give a great picture of the health of your business.
If your ratio is less than one percent, it means you are working with a negative cash flow. You will need to reevaluate your business model and address liquidity issues.
On the other hand, if that ratio is more than 2.0, it could mean that you are wasting potential opportunities to grow your business. You should consider reinvesting some of your profit into your business to expand.
An ideal working capital ratio is between 1.2 and 2.0. This shows that you’re operating with a healthy profit while also making good investments.
Need Help Growing Your Business?
Once you calculate net working capital, you might realize that you need some help to grow your business.
Contact us today to see how we can help.