Net working capital (NWC) is the difference between a business’s current assets and current liabilities. Hence the working capital formula to calculate Net Working Capital is current assets – current liabilities.
What are current assets?
Current assets are those items that can be converted into cash within a year. These include inventory, accounts receivables, short-term investments, and also cash.
What are current liabilities?
Current liabilities are debts or obligations that a business has to pay within a year. These include accounts payable, short-term debt, income taxes, interest payable, etc.
Businesses need to have more current assets than current liabilities at all times to avoid a downturn.
Importance of networking capital
A net working capital can be ensured as positive and negative. A positive net working capital ensures that the entity has ample funds to pay its short-term obligations. However, a higher capital means that it may have availed too many external funds.
On the other hand, negative net working capital means that the business is not generating ample profit to pay its short-term liabilities.
Negative net working capital can also be favourable for a business. The same can happen when an entity sells products quickly before it can pay its suppliers. Many a company like Dell and Wal-Mart have been subject to negative NWC.
How to improve NWC?
Some of the ways a business can improve its NWC include:
- First in, first out method to manage inventory
According to the first in, first out method, the inventory manufactured or purchased first must also be sold first. It is one of the simplest and practical ways to manage inventory and working capital if you run a manufacturing business. This method can also save a business’ time and the cost of goods sold when calculating the cost of inventory to be sold.
- Selecting vendors carefully
Another way to improve capital is by selecting the vendors who offer a long line of credit or discounts. Maintaining a cordial association with suppliers can help you keep avail benefits and improve your NWC.
- Refrain from financing fixed assets with NWC
Many a time, businesses finance fixed assets with their NWC when they don’t have the necessary funds. Doing so restricts them to cater to their current liabilities.
On the other hand, opting for a long-term loan is an ideal way to finance such purchases. Lenders offer loans against property or assets at an affordable rate of interest and prolonged tenors, specifically for the same.
- Opt for a loan
A working capital loan may be one of the correct solutions to opt for in times of crucial monetary needs.
- Secured loans
You can also hypothecate your assets as collateral and avail funds to finance your NWC, as mentioned earlier.
- Invoice financing
Another source of availing funds is to opt for invoice financing by pledging your bills receivable. The invoices act as collateral against which lenders provide loans.
- Collect bills receivable faster
Keeping your customers satisfied is critical to grow your sales and expand your business. However, you also have to make sure to collect the outstanding invoices faster. Send the bills as soon as possible for customers to receive the payments. Also, avail an advance payment before supplying your goods or services to your clients.
- Pay bills payable in time
Similar to the above, make sure that you pay your outstanding invoices in time. You can implement an electronic payment system to automate payments.
Now that you know the formula to calculate net working capital, calculate it, and take the measures mentioned above to improve it. Make to consider all factors before you avail external financing.