Before you dive in,
Remember these tips so all of the numbers, equations, and definitions don’t overwhelm you:
Working capital and net working capital are often used interchangeably which is perfectly acceptable in most scenarios.
The easiest way to define working capital is the difference between a company’s current assets and its current liabilities.
The simple way to figure out working capital is by subtracting your company’s current liabilities from your company’s current assets.
Working capital is needed for a company to meet its short-term obligations including things like payroll and paying suppliers or vendors.
Working Capital vs Net Working Capital
What Is Working Capital?
Working capital is the difference between a company’s current assets and its current liabilities. It tells you basically how much can easily be converted to cash to pay short-term debts and obligations. It’s an overall view of the company’s current liquidity, operational efficiency, and its short-term financial standing. You can calculate a company’s working capital by looking at its balance sheet.
Working capital accounts for assets and liabilities such as:
Accounts receivable: asset
Accounts payable: liability
When deciding to expand, make large purchases, buy investments, or hire more staff, a company would first take a look at its working capital to get a feeling of how it's doing, and if it can afford to spend some of its capital. For example, if its working capital is negative, it may not be the best time to purchase new machinery or do a round of hiring.
Additionally, companies may look at how much working capital they have and then decide they can afford to purchase more inventory to meet demands of an upcoming busy holiday season. Working capital can be increased by acquiring more assets and paying off short-term debts.
If a company needs help in covering everyday business expenses or keeping its cash flow stable, a working capital loan could be a good solution.
What Is Net Working Capital?
Net working capital is usually called working capital, so it too is the company’s current assets minus its current liabilities.
However, net working capital can also refer to the company’s total assets minus its total liabilities, instead of just calculating its current holdings. This means that net working capital can give a broader view of a company’s liquidity position; not just a short-term look. It offers a more long-term measure of a company’s financial standing. It takes into account both its short-term and long-term assets and liabilities.
What’s the Difference Between Working Capital and Net Working Capital?
Working capital vs net working capital: these terms are typically used interchangeably. Working capital is the more well-known expression but in most cases the terms mean the same thing: a company’s current assets minus their current liabilities.
Working capital is used to calculate a company’s current position and net working capital looks at a more long-term position because in some cases, it uses both short-term and long-term assets and liabilities in its calculations. Net working capital is generally more difficult to calculate and needs the company’s financial statements to all be in order and accurate. When using net working capital, you may not get the correct numbers because the company’s liquidity is constantly changing.
Formula for Calculating Working Capital/Net Working Capital
The formula for calculating working capital/net working capital is:
Total Current Assets - Total Current Liabilities = Working Capital/Net Working Capital
Example of Working Capital/Net Working Capital Calculation
Let’s look at an example so you know how to calculate working capital. Let’s assume that the company has total current assets of $150,000 and total current liabilities of $100,000. To calculate the working capital/net working capital, simply subtract the total current liabilities from the total current assets.
$150,000 - $100,000 = $50,000
The company has $50,000 in working capital/net working capital.
Why Is There Confusion Over the Difference Between Working Capital and Net Working Capital?
Most people view working capital and net working capital as being exactly the same. However, there are some people who use alternative definitions, so this can cause some confusion if you’re not sure which definition and calculation are being used.
Keep in mind that it’s always fine to ask which calculation is being used to avoid confusion, assumptions, and miscalculations. It’s better to clarify upfront, then to base your figures on the wrong calculations, while wasting time and resources.
Alternative Formula for Working Capital
Although most people, including the majority of financial analysts, view working capital and net working capital as being synonymous, there is a small minority that considers working capital to be the same as gross working capital. If you encounter this alternative definition, just remember that gross working capital is the sum of all of a business’ assets.
So the alternative formula for working capital would be:
Receivables + Inventory + Short Term Investments + Cash + Marketable Securities + Other Current Assets = Working Capital
Gross working capital does Not include any of the business’ liabilities or debt, so the alternative formula for working capital doesn’t include those either.
Example of Alternative Working Capital Calculation
Let’s check out an example of the alternative calculation of working capital and then how that differs from the traditional calculation.
Let’s assume the company has $50,000 in receivables, $30,000 in inventory, $20,000 in short-term investments, $25,000 in cash, $10,000 in marketable securities, $5,000 in other assets, and $50,000 in total liabilities.
Now, we have to remember that the alternative method doesn’t include the liabilities, so we just add up all of the assets which gives us a total of $90,000. This is the company’s gross working capital and the alternative definition of its working capital. The traditional calculation would then subtract the liabilities of $50,000 and be left with $40,000 in working capital. You can see there is a significant difference between the numbers in the two equations.
Alternative Formulas for Net Working Capital
There are two alternative formulas for calculating net working capital. In the first formula, cash and debt are removed from the standard equation. So, the equation is:
(Current Assets - Cash) - (Current Liabilities - Debt) = Net Working Capital
The second alternative equation simplifies net working capital and only includes:
Accounts Receivable + Inventory - Accounts Payable = Net Working Capital.
Examples of Alternative Net Working Capital Calculations
Alternative net working capital calculations differ from the traditional definition. For example, the first alternative equation removes cash and debt from the standardly used equation. The alternative equation look like this:
(Current Assets - Cash) - (Current Liabilities - Debt)
Let’s look at an example. Assume the company has $100,000 in total assets ($20,000 in accounts receivable, $20,000 in inventory, and $60,000 in other assets), $25,000 in cash, $10,000 in current liabilities ($3,000 in accounts payable and $7,000 in other liabilities), and $2,000 in debt. The equation would read as:
($100,000 - $25,000) - ($10,000 - $2,000) and the net working capital using this alternative method would equal $67,000.
The traditional method of calculation would Not subtract the cash or the debts. So, using the traditional net working capital calculation, the company would have $113,000 in net working capital. Gain, you can see a big difference in the calculations and the outcomes.
Let’s move on to an example of the second alternative equation for net working capital which is:
Accounts Receivable + Inventory - Accounts Payable = Net Working Capital.
Assuming that we use the same numbers from above, the equation would read as:
$20,000 + $20,000 - $3,000 = $37,000 in working capital. Once again, wildly different outcomes, so make sure you know which formula is being used first!