A small business owner is processing paperwork in front of a laptop. The net working capital ratio assesses a company's capacity to cover current liabilities with current assets. The net working capital ratio assesses a company's capacity to cover current liabilities with current assets. This ratio informs business owners about their company's liquidity and assists them in determining its overall financial health.
Net Working Capital: Definition and Examples
A net working capital ratio shows how effective a company is in paying off its current liabilities (outstanding short-term debt) with its current assets, giving shareholders a rough picture of its liquidity. The numerator and denominator of the net working capital ratio come from a company's balance sheet, and you can find them in the formula below:The formula for calculating the net working capital ratio
"Current ratio" is another name for the same thing. Here's an illustration: What is the net working capital ratio of a company with $1,000 in cash, $2,000 in accounts receivables, $2,000 in inventory, and $2,500 in current liabilities? Current Assets/Current Liabilities = Net Working Capital Ratio. Accounts Receivable + Inventory + Current Liabilities/Cash $1,000 x $2,000 x $2,500 x $1,000 x $2,000 x $2,500 x $1,000 x $2,000 x $2,500 x $1,000 x $2,000 x $2,500 x $1,000 x $2,000 x $2,500 x $1,000 x $2,000 x $2,500 x $1,000 x $2,000 x $2,500 equals 2.0 This suggests that the company's present asset base can cover its current liabilities twice over.What is the Net Working Capital Ratio and How Does It Work
The net working capital ratio is frequently misunderstood. Current assets minus current liabilities is a common definition. The net working capital ratio is calculated using that calculation, not the net working capital ratio. The difference between current assets and current liabilities is referred to as working capital, hence this equation requires subtraction. In the meantime, the net working capital ratio is a comparison of the two concepts that includes dividing them. Current assets are assets that have a one-year maturity. The term "current obligations" refers to debts that must be paid within a year. The ideal position for the company is to be able to cover its present liabilities using current assets rather than raise fresh capital. Cash, marketable securities, accounts receivable, inventory, and prepaid expenses are all examples of current assets. Accruals, accounts payable, and loans payable are examples of current obligations.An Extensive Example of Net Working Capital Ratio
Here's an expansion of the preceding example: What is the net working capital ratio if this company additionally has $1,000 in marketable securities and $3,000 in loans payable on its current liabilities? Current Assets/Current Liabilities = Net Working Capital Ratio. Current Liabilities + Accounts Receivable + Inventory + Marketable Securities $1,000 x $2,000 x $2,000 x $1,000 x $2,500 x $3,000 x $1,000 x $2,500 x $3,000 x $1,000 x $2,500 x $3,000 x $1,000 x $2,500 x $3,000 x $1,000 x $2,500 x $3,000 x $1,000 x $2,500 x $3,000 x $1,000 x $2,500 x $3,000 x $1,000 x $2,500 x $1,000 = $6,000/$5,500/$6,000/$5,500/$6,000/$5,500 = 1.09 occurrences This suggests that the company can cover its present liabilities at 1.09 times, but only just. The net working capital ratio, as previously stated, is a measure of a company's liquidity, or how quickly its assets may be converted to cash. The net working capital ratio can go below 1.0 if the business has fewer credit customers (accounts receivable) than planned, or if it has less inventory, cash, or marketable securities than expected, as shown in the extended example. If this occurs, the company will need to seek capital to pay off all of its short-term debt and current commitments. In reality, you'll want to examine ratios over time to see if the net working capital ratio is increasing or decreasing. You can also compare your ratios to those of other companies in your industry. A net working capital ratio of 1.5 to 2.0 is considered ideal and indicates that your company is better prepared to pay off its current creditors.Important Points to Remember
- The net working capital ratio determines a company's ability to repay current creditors with current assets and so gauges its liquidity.
- The difference between current assets and current liabilities is known as working capital, whereas the net working capital calculation contrasts current assets and liabilities.
- The ideal net working capital ratio for a business is 1.5 to 2.0, but this might vary depending on the industry.
- A corporation should have comparative data from past time periods of operation or from its industry to properly assess a financial ratio.
