What Is The Net Working Capital Formula For Small Businesses?

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When it comes to the responsibilities of business owners, very few can match the importance of staying on top of the right numbers. This includes profitability, performance data, and of course, working capital. Small business owners must constantly keep tabs on how much working capital they have on hand. Without this information, countless critical tasks – from ordering the correct amount of inventory to obtaining the perfectly sized small business loan – become much harder, if not impossible.

The net working capital formula allows you to see exactly how much cash you can spend at this time along with whether or not your business has enough assets to cover short-term expenses. This equation requires just two numbers: your business’s current assets and your business’s current liabilities.

In this guide, we’ll explain how to calculate working capital, what the answer to the equation means for your business, and how to raise your net working capital.

What Is Working Capital?

The term “working capital” refers to all assets currently available for covering monthly business expenses, or operational costs. Working capital typically covers payroll, rent, supplies, vendor bills, debt payments and other day-to-day expenses. In addition to keeping your business up and running, working capital funds growth-related initiatives, like hiring more workers or acquiring more customers.

Why Should I Calculate Working Capital?

Net working capital doesn’t just reflect the value of your assets and cash. It also represents your business’s overall financial health and ability to capitalize on opportunities. More working capital increases your business’s capacity for growth and chances for survival in the event of an emergency. You can even think of working capital as your business’s life counter. The less working capital your business has, the shorter its projected lifespan becomes. It’s no wonder insufficient working capital ranks among the most common reasons for business failure.

Continuing to apply the net working capital formula, however, greatly decreases the chances of losing control of your finances.

What Is the Net Working Capital Formula?

To calculate your business’s net working capital, simply subtract your current liabilities from your current assets. The numbers that make up both parts of the equation should appear on your most recent balance sheet.

Current Assets = What your business owns (Cash, Inventory, Accounts Receivable, etc.)

Current Liabilities = What your business owes (Bills, Payroll, Loans, Accounts Payable, etc.)

Net Working Capital = Current Assets – Current Liabilities

Your current assets must exceed your current liabilities in order to meet short-term obligations. This, if you intend to grow your business, you should look to increase the gap between what your business owns and what your business owes.

Net Working Capital Formula Example

To better illustrate how to calculate net working capital, we’ll use an example featuring hypothetical assets and liabilities. This particular scenario uses yearly numbers to determine what the sample business’s finances will look like at the end of the year. Many financially conscious businesses, however, calculate net working capital every month or every quarter.

Current Assets Available For Coming Year

  • Cash on hand: $300,000
  • Accounts receivables: $500,000
  • Inventory: $800,000

Total current assets = $4.3 million

Current Liabilities Owed For Coming Year

  • Accounts payable: $400,000
  • Short-term debt payments: $50,000
  • Portion of long-term debt due this year: $50,000
  • Operational Expenses: $600,000

Total current liabilities = $1.1 million

Net Working Capital = Current Assets – Current Liabilities

$4.3 million – $1.1 million = $3.2 million

By calculating net working capital, we can see that after paying all liabilities for the year, the sample business will have approximately $3.2 million left over. With all expenses out of the way, some of this leftover money can go in the bank, with the other portion going towards growth-related initiatives.

Working Capital Ratio

The net working capital formula will produce an amount in dollars. Sometimes, though, looking at this number won’t immediately tell you if you have healthy working capital. Due to individual factors like industry or company size, what seems like healthy working capital for one business could represent the bare minimum for another.

The answer to your working capital ratio, on the other hand, leaves no room for uncertainty. While the net working capital formula subtracts assets from liabilities, the working capital ratio formula divides them.

Current Assets / Current Liabilities = Working Capital Ratio

If your working capital ratio ranges between 1.2 and 2.0, you have healthy working capital, regardless of the aforementioned factors. Anything higher than 2.0, however, might suggest insufficient spending or too much unused working capital. Maybe you’ve neglected to invest enough profits back into the business or failed to spend enough money to generate growth.

What Counts As Current Assets and Liabilities?

It’s only natural to find the terms “assets” and “liabilities” confusing. Different business owners and finance professionals tend to have different definitions for each term. We’re going to use the most generally accepted definition in this guide.

Let’s start with assets.

According to the general definition, current or “liquid” assets refers to cash and anything that you can convert to cash within the maximum span of one year. Examples include inventory, outstanding accounts receivable or stock the business holds in another company. This differs from long-term assets, which refers to assets that you cannot easily convert into cash within one year’s time. This can include real estate, equipment, copyrights, etc.

Now for liabilities.

Current liabilities refer to all loans or expenses that you owe within the maximum span of one year, or the company’s standard operating cycle. Examples include short-term business loans, accounts payable, and accrued expenses like taxes and wages.

Understanding the difference between current assets and long-term assets can prevent you from having too much money tied up in the latter variation. This would significantly decrease your working capital. You should instead strive for an equal balance between the two.

Is Negative Working Capital Always Bad?

Most types of businesses cannot succeed with negative working capital, or when their current liabilities exceed their current assets. In some industries, however, negative working capital does not necessarily signify poor cash flow. These businesses do not need large amounts of working capital to continuously sustain operations.

Many fast food chains, for example, never go one day without making multiple sales. They always have cash flowing in but must constantly spend it to serve their customers, rather than saving it up. This often results in negative working capital.

Businesses that can succeed with negative working capital also don’t need to expand in order to survive. Negative working capital prevents you from growing anytime soon. But certain businesses, like grocery stores, will do just fine without having to increase staff, marketing, or other resources.

Lastly, the incredibly high inventory turnover rates of fast food chains and grocery stores technically offsets their negative working capital. This means they have typically more cash than unsold inventory, and the value of the former greatly outweighs the latter.

How To Build More Working Capital

Profitability, cash flow and working capital tend to get lumped together. This makes sense because improving one of these things almost automatically improves the two others. The best practices for improving profitability, for example, will usually end up improving cash flow and working capital as well.

In other words, you don’t really have to think “outside the box” when developing strategies for improving your net working capital. Rather than focusing exclusively on working capital, you might want to simply focus on the most effective strategies for improving your finances in general. Anything that helps you save money or make more money will likely lead to more working capital.

Let’s reiterate those best practices here:

Decrease Spending

No strategy will increase working capital more quickly than freeing up as much cash as possible. When reviewing your financial statements, think about which expenses you can cut or reduce. After going over smaller expenses (memberships, software tools, travel, etc.), you can move on to bigger expenses like labor and the cost of goods sold.

You may conclude that employee salaries make up your biggest expense, by far. If so, consider doing more with less people. For example, instead of hiring new employees to perform additional tasks, you might want to train current employees to handle them. You’d have to pay them more money, but nowhere near as much as you’d have to pay new employees.

As for the cost of goods sold, you may have earned the right to ask suppliers for better rates or discounts on certain orders. Do you always pay on time? Do you regularly order from this supplier? Customers with long track records of orders and timely payments shouldn’t worry about overstepping their boundaries by asking for the occasional discount.

Decrease Late Payments

Decreasing your accounts receivable cycle makes each sale more profitable and therefore increases working capital. You could accomplish this by sending more than one invoice per month with the help of an automated invoice system. Other strategies include offering discounts to customers who pay early or only offering 30-day terms to new customers, or existing customers with flawless payment histories.

Don’t Order Too Much Inventory

The longer an item sits on your shelves, the less profitable it becomes. Most retail-oriented businesses should therefore try to only order enough inventory to satisfy the current level of demand. Popular tactics for this objective include better forecasting of demand or using lines of credit to practice “last minute” inventory management. The latter option would give you extra cash to place orders despite slower revenue or less operational funding at your disposal.

Lower Monthly Debt Payments

Spending too much money on monthly debt payments takes away working capital. The debts costing you the most money likely have the highest interest rates. For that reason, you should focus on eliminating these debts as quickly as possible.

Instead of continuing to make minimum payments, see if you can afford to pay more each month. Once you’ve paid off that debt, apply the same principle to the debt with the next highest interest rate, and so on.

How Net Working Capital Affects Access To Business Loans

Many financial institutions prioritize working capital when deciding whether to approve or reject an application. The more working capital you have on hand, the higher the likelihood of being approved for high amounts, convenient terms, and low interest rates.

Banks, for example, offer the cheapest business loans on the market because they usually work with heavily capitalized applicants. Such applicants tend to have so much working capital saved up that they don’t actually need the bank’s money. If the business went under or the investment turned sour, the business would still have no trouble paying off the loan.

Companies like United Capital Source, however, frequently work with younger, under-capitalized businesses. After all, businesses need more working capital to grow. The right type of business loan could supply that extra capital and eventually generate more revenue, profits, and, you guessed it, working capital.

Best Business Loans For Extra Working Capital

Several types of business loans contain repayment structures geared towards short-term investments. This makes them ideal for businesses in need of extra working capital, as opposed to much larger sums of cash. You could use the funds to finance day-to-day operations, pay off existing debts, hire more workers or take advantage of sudden opportunities. These functions

have low to moderate costs, so smaller businesses won’t struggle to pay off the debt. Business loans geared towards long-term investments, on the other hand, tend to have higher borrowing amounts and longer terms. Companies interested in these loans have plenty of working capital and will most likely use the money for game-changing initiatives.

The following business loans fulfill the former criteria:

  • Short-Term Business Loans: Just like the standard, traditional business loan, only with shorter terms ranging from 3-18 months.
  • Working Capital Loan: This borrowing amount for this loan directly reflects the monthly costs of running your business. The terms and repayment structure usually resemble those of short-term business loans.
  • Business Line of Credit: You can borrow from your credit line at any time, and you only make payments when you borrow.
  • Merchant Cash Advance: You receive a lump sum that is paid back via a fixed percentage of daily debit and credit card sales.
  • Revenue Based Business Loan (Business Cash Advance): Similar to MCA, but your payments are deducted via a fixed percentage of your entire monthly revenue.
  • Invoice/Accounts Receivable Factoring: The financial institution purchases your outstanding invoice/receivable for a discount price and pays you right away.

Where To Find Business Loans For Working Capital

The following institutions carry at least one of the products listed above. They have looser requirements for approval due to the products’ shortened terms and higher rates. This includes the applicant’s working capital situation. While banks might ask for years’ worth of financial information, these institutions typically only require three months’ worth of bank statements. They just need to see that your business has healthy cash flow at this specific moment. Having so little paperwork to go over allows the institutions to approve and distribute funding in just 24-48 hours.

Kabbage

Kabbage offers just one program; a business line of credit. There’s no minimum personal credit score, but most borrowers reportedly have scores of at least 500. Borrowers must be in business for at least one year and have an annual revenue of at least $50,000. You can borrow up to $250,000.

OnDeck

Ondeck offers short-term business loans and lines of credit. For short-term business loans, borrowers must have a personal credit score of 500+, 1+ years in business and $100,000+ in annual revenue. For business lines of credit, borrowers must have a personal credit score of 600+, 1+ years in business and $100,000+ in annual revenue. Most borrowers reportedly have scores of 660 or higher.

For short-term business loans, you can borrow up to $500,000, compared to $100,000 for business lines of credit. Payments for short-term business loans must be made daily or weekly.

BlueVine

BlueVine offers business lines of credit and invoice/accounts receivable factoring. For a 6-month business line of credit, borrowers must have a personal credit score of 600+, 6+ months in business, and $120,000+ annual revenue, 12-month line of credit: 620+ personal credit score, 2+ years in business, $450,000+ annual revenue.

You can borrow up to $2,000 – $250,000 for each LOC. Invoice/Accounts Receivable Factoring: 530+ personal credit score, 3+ months in business, $100,000+ annual revenue. You can borrow $20,000 – $5 million.

Credibility Capital

For a short-term business loan, borrowers must have 680+ personal credit score, 2+ years in business, and $250,000+ in annual revenue. You can borrow up to $250,000.

StreetShares

For a short-term business loan and business line of credit, borrowers must have 600+ personal credit score, 1+ year in business, and $75,000+ annual revenue. You can borrow up to $250,000 for both. For invoice/ accounts receivable factoring, borrowers must have 540+ personal credit score, and 1+ year in business, with no requirement for annual revenue. You can borrow up to 90% of invoices and 80% to 90% of government contracts.

United Capital Source

United Capital Source offers all of the programs listed above. For all five, borrowers must be in business for at least six months and earn $100,000 in annual revenue. Borrowers with low credit scores (around 500) can be approved for short term business loans, merchant cash advances, business lines of credit, and revenue based business loans.

You can borrow up to $250,000 for a business line of credit, $1M for a merchant cash advance, $10,000 – $5M for a working capital loan and business cash advance, and $10,000 – $10M for invoice/accounts receivable factoring.

Required Documents

Here is the paperwork required for most of these products:

  • Driver’s License
  • Voided Business Check
  • Bank Statements
  • Credit Score
  • Business Tax Returns
  • Credit Card Processing Statements
  • Proof of Ownership

Improving Net Working Capital: Recap

Working capital doesn’t just represent your business’s liquidity. If you have healthy working capital, or positive working capital, it shows firm control over the most important elements of your business. If one of those elements begins to slip, your working capital will likely do the same. So, as long as you keep an eye on cash flow, profitability, expenses, revenue, etc., you won’t have to worry about working capital problems going unnoticed. And if one such problem does arise, the solution will appear right alongside it.

The post What Is The Net Working Capital Formula For Small Businesses? appeared first on United Capital Source.

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