The net working capital ratio is the net amount of all elements of working capital. It is intended to reveal whether a business has a sufficient amount of net funds available in the short term to stay in operation. Use the following formula to calculate the net working capital ratio:
This measurement only provides a general idea of the liquidity of a business, for the following reasons:
- It does not relate the total amount of negative or positive outcome to the amount of current liabilities to be paid off, as would be the case with a real ratio.
- It does not compare the timing of when current assets are to be liquidated to the timing of when current liabilities must be paid off. Thus, a positive net working capital ratio could be generated in a situation where there is not sufficient immediate liquidity in current assets to pay off the immediate requirements of current liabilities.
For example, a business has $100,000 of cash, $250,000 of accounts receivable, and $400,000 of inventory, against which are offset $325,000 of accounts payable and $125,000 of the current portion of a long-term loan. The calculation of the net working capital ratio would indicate a positive balance of $300,000. However, it can take a long time to liquidate inventory, so the business might actually find itself in need of additional cash to meet its obligations in the short term, despite the positive outcome of the calculation.
An alternative version of the ratio compares net working capital to the total amount of assets on the balance sheet. In this case, the formula is:
(Current assets - Current liabilities) ÷ Total assets
Under this second version, the intent is to track the proportion of short term net funds to assets, usually on a trend line. By doing so, you can tell if a business is gradually shifting more of its assets into or out of long-term assets, such as fixed assets. An increasing ratio is considered good, since it implies that a business is minimizing its investment in fixed assets and keeping its asset reserves as liquid as possible.