Net working capital is a financial metric a business owner can use in order to help measure the cash and operating liquidity position of the business firm.
The net working capital metric is directly related to the current ratio. If you look at the calculation of the current ratio, you see that you use the same balance sheet data to calculate net working capital.
Here is the calculation for Net Working Capital: Current Assets - Current Liabilities = Net Working Capital.
If a business firm has current assets of $200 and current liabilities of $100, then:
- Net Working Capital = Current Assets - Current Liabilities
- $200 - $100]
- Net Working Capital = $100
This firm can pay its short-term debt obligations and still have $100 left over as a cash or operating liquidity cushion. It has twice the current assets ($200) as current liabilities ($100)
Compare this to the current ratio. If you calculate the current ratio for this example, you would use the current ratio formula:
- Current Ratio = Current Assets/Current Liabilities
- $200/$100 = 2.00X
- Current ratio = 2.00X
You can see the relationship between the two financial metrics.
Cash management and the management of operating liquidity is important for the survival of the business firm. A firm can make a profit, but if they have a problem with their cash position, they won't survive. This is why it is important for a business owner to use all the financial metrics and measures available to manage liquidity and cash.