Net working capital is the money a business uses to operate their business. Short term and long term, net working capital is an important component for a business to have. Therefore, it is important for small businesses to consider some ways in which they can increase their current assets and possibly shorten their dependence on outside funds.
Creating an emergency fund is often one of the best ways for a small business to increase their current working capital needs. Emergency funding can provide a steady flow of money that can help to alleviate short term cash flow problems. However, the best solution is to use this working capital in conjunction with other working capital needs. To do this, a business must carefully examine all their existing short term assets. Once the company has determined which are their most pressing short-term needs, then they should look for opportunities that offer them the best solutions.
For example, if a business is experiencing problems paying its bills then their net working capital ratio will be too high. They may then turn to their short-term assets such as inventory to generate the cash they need to solve their problem. But if the inventory turns out to be unprofitable, then they may have to cut back on their inventory purchases and experience a net loss instead of gaining any profits on the sale of the inventory. This is why it is important to review your short-term assets and liabilities along with your current assets and liabilities. The analysis should identify both long-term liabilities that can be turned into short term assets if necessary, and short-term assets that will generate profits if you are able to resolve the problems that are causing them to exist.
Another common way for a business to increase their current assets and liabilities is by utilizing their current assets for more immediate working capital needs. This means a business must identify its most liquid short and long-term assets, then utilize those assets immediately. A common example of this is a retailer purchasing goods in stock that it plans to sell at a later date. By purchasing the stock from the wholesaler at an agreed upon price, the retailer can avoid the cost of inventory, sales tax, and payment processing fees. The net effect of purchasing these items is that they create current assets for immediate use that increase the net working capital.
Net working capital ratios can also be improved by identifying all of a company’s expenses including its short-term liabilities such as accounts receivable, inventory, and short-term loans, and identifying its long-term assets including accounts payable. In addition, all long-term debts should also be included in the current assets table to show them as assets. A company should examine its current sales revenue, its gross profit margin, and its free cash flow in order to determine which of these items it should increase its current assets to improve its net working capital ratios. If the gross profit margin decreases, then the business has fewer funds available to invest in short-term assets and incur additional short-term liabilities.
A company should also examine its short-term and long-term debts to identify those that require more cash flow generation and is less likely to be replaced with current assets. These debts typically include accounts payable, accrued expenses, and payroll obligations. A company should calculate its net working capital ratios for each category of its current liabilities and calculate the effect of an interest rate change on its current assets and current liabilities including its short-term debt.
Net working capital needs can also be improved by increasing cash flow generated through the use of revolving credit. A company should examine its existing lines of credit, to identify the types of investments the company currently makes that generate cash that can be used to finance its short-term liabilities. In addition, the analysis should identify the operating procedures, methods, and timing of the investments to determine whether the method(s) are effective for generating cash that will be needed for its short-term working capital needs. For example, a company could improve its cash flow by replacing nonperforming investments with new ones that generate steady cash flows.
Net working capital consists of two components, namely, current assets and current liabilities. The company’s current assets mainly consist of accounts receivable from customers and inventory. Its current liabilities include accounts payable to suppliers, tenants, and subcontractors. All of the company’s assets and liabilities can be examined in isolation, or, they can be combined to assess the total net working capital. A company should first examine its current assets and liabilities and identify the total net worth of the business before looking at its net working capital needs.