Net working capital measures a company's liquidity, efficiency, and overall financial health at the time when it is calculated. To figure this amount, also known as the working capital ratio, its current liabilities of a company are subtracted from current assets. A positive ratio indicates the ability to pay off creditors and make improvements to the business, while a negative ratio indicates financial distress. Comparing net working capital amounts over different periods of time is useful in determining areas where a company is having success with its cash management and areas where it needs improvement.
Simply turning a profit doesn't ensure financial success for an individual company, especially if that profit doesn't translate into capital that can be used to improve the business. Measuring the net working capital is a good way to measure a company's cash management and, more importantly, its ability to operate without falling behind in its financial obligations. The working capital ratio is determined by taking all of the company's various assets — which can come in the form of cash, stocks, accounts receivable, or inventory — and subtracting its liabilities, which usually take the form of accounts payable.
For example, imagine a company that has a total of $500 U.S. Dollars (USD) worth of assets and $250 USD in liabilities. In that situation, subtracting the $250 USD from the $500 USD would leave $250 USD of net working capital. This essentially means that if the company was forced to immediately make good on all of its accounts payable, it would still have $250 USD remaining in the bank.
This ratio is similar to the current ratio, which is calculated by dividing a company's assets by liabilities. For example, using the numbers above, that company's current ratio would be 2.00, which is the result of dividing the $500 USD by $250 USD. In both cases, a positive ratio indicates that a company has the ability to pay its debts and make improvements, while a negative ratio is problematic and means the company needs to improve its financial health.
The net working capital can also be a good indicator of a company's efficiency. A company that has solid sales figures and still suffers with low amounts of capital may be inefficient in either collecting payments or capitalizing on inventory. By measuring working capital ratios over several different time periods, trends may be revealed which show whether a company's capital is strong and steady in the long-term or if some sort of correction needs to be made to reverse a decline.