On a company’s balance sheet, you will find assets on one side and liabilities on the other. From this financial information, one is able to calculate a company’s net working capital ratio.
What is the net working capital ratio?
A company’s net working capital ratio is how well or how much the company is able to pay off its current liabilities with its current assets. Business people consider a company’s net working capital ratio as one of the most important metrics to measure general liquidity.
Though used interchangeably, net working capital is not the same as working capital. The former takes on a broader and more general view of a company’s liquidity, whereas working capital is more short-term, and covers a smaller timeframe. Working capital is expressed as a dollar figure, while net working capital ratio is a digit.
Working capital = Current Assets – Current Liabilities
You can tell a company’s financial health by considering this ratio. The formula is as follows:
Net Working Capital Ratio = Current Assets/ Current Liabilities
A good net working capital ratio of 2:1, that is, the company has twice the amount of money in current assets in its possession than the current liabilities it owes, is preferred.
If a company has a net working capital ratio of less than one, it means that it cannot pay off its current debt using its current assets. When current liabilities exceed current assets, the net working capital ratio is negative and should be a warning sign of impending bankruptcy.
What are current assets?
The term ‘current’ refers to a financial period of 12 months or less. Current assets are properties or possessions that a company owns and can be quickly converted to cash to cater to urgent needs. They are sometimes called liquid assets because of how quickly they are to change to cash if they are not cash already.
Some of the common examples of current assets include:
- Cash on hand
- Money in banks that can be withdrawn at any time.
- Accounts receivable: Money lent out to customers so that it can be collected rightfully and at any time by the company.
- Inventory: Items such as stock that can be sold and bring revenue.
Companies like Berkshire Hathaway, which had more than $138 billion in cash in 2020, have what is called a fortress balance sheet in that their current assets greatly outweigh any liabilities they may have.
A benefit of having many current assets is that the company is sheltered from adverse economic shifts. If sales drop massively, the company can still comfortably pay off its bills and debts.
Having too many current assets in a company’s portfolio is not all rosy; it could reveal poor management skills. Be wary of companies with too much cash; why are they not saving it in a bank? Besides, if the company takes out a loan, all these current assets will be considered liabilities, as they will now be used to repay the loan.
What are current liabilities?
These are short-term debts that the company should pay within a year. A company should ensure that it has enough current assets to pay off its liabilities within an operating cycle. Some of the current liabilities you would see on a company’s balance sheet include the following:
- Accounts payable. This is money that suppliers haven’t paid.
- Short-term bank loans
- Dividends payable
- Income taxes
Dynamics of net working capital ratio
For formulas with a numerator and denominator, changes on either side could lead to the ultimate change of the solution. In this case, have a look at the formula once more:
Net Working Capital Ratio = Current Assets/ Current Liabilities
Let’s have an example. A company’s current assets total to $500,000 and its current liabilities are $300,000. Its net working capital ratio is:
500,000/ 300,000 = 1.7
The company can pay off its current liabilities at least 1.7 times using its current assets. While this is okay, it is not exemplary. A net working capital ratio of 1.5 to 2 is best preferred, but the higher the better.
Let’s tweak the numbers to see the difference it would make. Every other part of the formula remains unchanged; shift in values is by $100,000.
- Increase the value of current assets
NWC = CA / CL
NWC = ($500,000+$100,000) / $300,000
NWC = 2
- Increase the value of current liabilities
NWC = CA/ CL
NWC = $500,000 / ($300,000 + 100,000)
NWC = 1.25
- Decrease the value of current assets
NWC = CA/ CL
NWC = ($500,000 - $100,000) / $300,000
NWC = 1.3
- Decrease the value of current liabilities
NWC = CA/ CL
NWC = $500,000 / ($300,000 – 100,000)
NWC =2.5
Assumptions: Can a company increase its net working capital ratio?
The only way we can ensure a high net working capital ratio for our company, using the examples above, is by:
- Increasing the value of current assets. This can be done by having more cash, increasing inventory reserves, and earning more cash discounts.
- Decreasing the value of current liabilities. This can be achieved by debt avoidance, getting the best credit terms, and embracing better spending habits.
- Other strategies include shortening operating cycles and avoiding financing fixed assets using working capital.
Another ratio may be used with the net working capital ratio, called the acid-test or quick test. It compares the most liquid assets, such as cash and no inventory. Using the acid test, you will know how well or poorly your company’s liquid assets compare with the current liabilities. If an emergency happened now, would the company’s current assets be immediately overwhelmed by the current liabilities?
Benefits of an optimal net working capital ratio
A good net working capital ratio reveals that the company has effective liquidity and can take care of its debts as quickly as possible without any losses.
Demerits of an optimal net working capital ratio
While having an optimal net working capital ratio is effective and encouraged, it gives the company a false sense of security. Liquidity is very volatile, and relying on it as a company’s financial metric could be misleading.
