MEANING
The net working capital ratio measures a business’s ability to pay off its present liabilities with its existing assets.
Key Takeaways
The net working capital ratio determines the liquidity of a service by determining its ability to repay its current liabilities with its current assets.
Operating capital is the difference between current assets and existing liabilities, while the net working capital calculation compares existing properties and current liabilities.
An optimal net working capital ratio is 1.5 to 2.0, but that can depend on business’s industry.
To properly interpret a financial ratio, a service needs to have relative data from previous period of operation or from its industry.
Meaning and Examples of the Net Working Capital Ratio
A net working capital ratio offers entrepreneur a general idea of their company’s liquidity by showing how effective it is at settling its current liabilities (outstanding short-term debt) with its current properties. The net working capital ratio’s numerator and denominator come from a business’s balance sheet, and you can find them in the formula below:
Net working capital ratio formula
Alternate name: Current ratio
Here’s an example: If a company has $1,000 in money, $2,000 in accounts receivables, $2,000 in stock, and $2,500 in existing liabilities, what is its net working capital ratio?
Net Working Capital Ratio = Current Assets/ Current Liabilities
= Cash + Accounts Receivables + Inventory/ Current Liabilities
= $1,000 + $2,000 + $2,000/$ 2,500.
= 2.0.
This suggests the business can cover its current liabilities two times over with its current possession base.
How the Net Working Capital Ratio Works.
The net working capital ratio is sometimes defined incorrectly. You might see it defined as existing properties minus present liabilities. That equation is really utilized to figure out working capital, not the net working capital ratio.
Keep in mind.
Operating capital refers to the distinction in between present assets and present liabilities, so this formula involves subtraction. The net working capital ratio, on the other hand, is a comparison of the two terms and includes dividing them.
Current assets refer to those assets that develop within one year. Present liabilities describe those debts that the business need to pay within one year. The preferable circumstance for the business is to be able to pay its present liabilities with its current properties without needing to raise brand-new financing.
Existing properties typically consist of cash, valuable securities, accounts receivable, stock, and pre-paid costs. Present liabilities consist of accruals, accounts payable, and loans payable.
Extended Example of Net Working Capital Ratio.
Here is an extension of the example utilized formerly:.
If this company likewise has $1,000 in valuable securities, and the existing liabilities consist of $3,000 in loans payable, what is the net working capital ratio?
Net Working Capital Ratio = Current Assets/ Current Liabilities.
= Cash + Accounts Receivable + Inventory + Marketable Securities/ Current Liabilities + Loans Payable.
= $1,000 + $2,000 + $2,000 + $1,000/$ 2,500 + $3,000.
= $6,000/$ 5,500.
= 1.09 Times.
This means business can cover its present liabilities– but simply hardly– at 1.09 times.
As discussed above, the net working capital ratio is a step of a company’s liquidity or how quickly it can transform its assets to money. In the prolonged example offered, you can see that if the business has fewer credit customers (receivables) than prepared for, or if it has less inventory, money, or marketable securities than expected, the net working capital ratio can fall below 1.0. If that happens, then business would need to raise financing to pay off even its short-term financial obligation or existing liabilities.
Keep in mind.
In reality, you want to compare ratios throughout different time periods of information to see if the net working capital ratio is increasing or falling. You can also compare ratios to those of other companies in the very same industry.
An excellent guideline is that a net working capital ratio of 1.5 to 2.0 is considered optimum and shows your organization is better able to pay off its existing liabilities.
