Managing finances and expenses is a crucial part of owning and operating a business. The type of business or the industry in which you operate will also determine your accounting method. Regardless of what type of business you own or how you calculate your sales, revenue, and expenses, determining the overall financial health of your business comes down to one primary number: net working capital.
According to the U.S. Small Business Administration there are 28.8 million small businesses in the United States, which account for 56.8 million jobs throughout the country. In fact, small businesses (with less than 500 employees) account for 99.7% of all business in the United States.
Although the number of small businesses in the United States is clearly impressive, only approximately two-thirds of those businesses survive more than two years in business, only 50 percent will survive five years, and only one-third survive 10 years. What is the main reason for this? Plain and simple, money.
This is why it’s important for small businesses to keep track of finances, investments, expenses and net working capital in their early days. By having a good handle on cash flow, money management, and net working capital, businesses have a higher chance of surviving – even through slower periods.
What is Net Working Capital?
Net working capital is the amount of money a business has available to spend on daily operations, such as paying short term bills and purchasing inventory. Net working capital involves looking at a company's total current assets and total current liabilities.
Current assets are considered a company’s financial resources, such as cash and accounts receivables.
Current liabilities are what a company owes to others, such as accounts payables that the company expects to pay within a year.
Total Current Assets - Total Current Liabilities = Net Working Capital
Net working capital is calculated by subtracting the total current liabilities from total current assets.
All in all, having more net working capital helps a company run its business more efficiently, and having a sufficient amount of cash is more preferred over receivables due to the risk of a customer default.
How to Determine Your Company’s Net Working Capital
It can be difficult to build up net working capital and enough cash to keep operations running smoothly, to keep customers happy, and to keep earning a paycheck. Read on to learn some top tips on how to calculate your net working capital and why it is important.
1. Start with the Balance Sheet. To calculate your net working capital, the first place to start is with your balance sheet, which should be easily accessible in any accounting system or software. This is typically referred to as the "Total Current Assets" line item in the "Assets" section of a balance sheet.
2. Identify the “Total Current Liabilities”. Now that you have found your company’s total current assets, the next step is to identify the total liabilities. Refer to the line item titled “Total Current Liabilities” which can be found in the “Liabilities” section of the balance sheet.
3. Subtract Liabilities from Assets. As mentioned briefly above, to calculate your company’s net working capital, subtract the company's total current liabilities from its total current assets to calculate its net working capital.
For example, for the sake of easy math, say that the company’s “Total Current Assets” are $40,000, the “Total Current Liabilities” are $10,000, then the company’s net working capital is $30,000. Not bad.
4. Determine the Net Working Capital. If your company’s net working capital is a positive number, then this means your business has enough current assets and sufficient cash flow after paying the bills and liabilities.
On the other hand, if your company’s net working capital is negative, then this means that your business does not have enough assets or cash flow to pay its bills. At this point, it may be best to research methods for obtaining additional funds.
5. Determine Your Competitive Position. In order to determine where your business is compared with your competitors, compare your total net working capital and current assets with your competitors within your industry. This will help you determine your competitive position and advantage.
It’s essential for businesses to calculate net working capital and to be aware of their financial as well as their current competitive position in order to maintain positive net working capital and sufficient cash flow. Not only will this enable businesses to pay short term bills and liabilities, it will also allow businesses to save cash reserves to get them through slower periods and ensure long-term survival.