Alternate name: Current ratio
Here’s an example: If a business has $1,000 in cash, $2,000 in accounts receivables, $2,000 in inventory, and $2,500 in current liabilities, what is its net working capital ratio? Net Working Capital Ratio = Current Assets / Current Liabilities = Cash + Accounts Receivables + Inventory / Current Liabilities = $1,000 + $2,000 + $2,000/$2,500 = 2.0 This means the business can cover its current liabilities twice over with its current asset base.
How the Net Working Capital Ratio Works
The net working capital ratio is sometimes defined incorrectly. You may see it defined as current assets minus current liabilities. That equation is actually used to determine working capital, not the net working capital ratio. Current assets refer to those assets that mature within one year. Current liabilities refer to those debts that the business must pay within one year. The desirable situation for the business is to be able to pay its current liabilities with its current assets without having to raise new financing. Current assets typically include cash, marketable securities, accounts receivable, inventory, and prepaid expenses. Current liabilities include accruals, accounts payable, and loans payable.
Extended Example of Net Working Capital Ratio
Here is an extension of the example used previously: If this business also has $1,000 in marketable securities, and the current liabilities include $3,000 in loans payable, what is the net working capital ratio? Net Working Capital Ratio = Current Assets / Current Liabilities = Cash + Accounts Receivable + Inventory + Marketable Securities / Current Liabilities + Loans Payable = $1,000 + $2,000 + $2,000 + $1,000/$2,500 + $3,000 = $6,000/$5,500 = 1.09 Times This means the business can cover its current liabilities—but just barely—at 1.09 times. As mentioned above, the net working capital ratio is a measure of a firm’s liquidity or how quickly it can convert its assets to cash. In the extended example provided, you can see that if the business has fewer credit customers (accounts receivable) than anticipated, or if it has less inventory, cash, or marketable securities than expected, the net working capital ratio can fall below 1.0. If that happens, then the business would have to raise financing to pay off even its short-term debt or current liabilities. A good rule of thumb is that a net working capital ratio of 1.5 to 2.0 is considered optimal and shows your business is better able to pay off its current liabilities.
