Net Working Capital to Total Assets
Net Working Capital to Total Assets is the tool to measure a company’s net working capital to its assets. It is the percentage of working capital to company total assets. It represents how strong the company’s financial health regarding the liquidation. It also shows the management risk tolerance toward the investment opportunity and risk of liquidation.
Net working capital is the difference between current assets and current liability. It is positive when current assets are higher than current liability. Company uses it to measure the ability to use the current assets to pay for the current liability. As we know, current assets are items that are easily covert to cash, so it is very helpful to access current assets balance. They are the first items that company needs to use to pay for the short-term obligation.
The comparison of net working capital to total assets is the ratio that company allocates its capital. The company capital is raised from both share equity and debt. Most companies consist of both types of capital. The company uses this capital to fund the total assets which include both fixed assets and current assets. Company invests in fixed assets to expand the operation for long-term benefit.
Moreover, the company needs current assets to support its daily operation such as paying for employees, suppliers, and so on. Less working capital will cause some problems for the company. However, if a company keep too much working capital, they need to decrease other investment such as fixed assets. It will decrease the profit in the long term, so they need to balance the working capital and other investment which depend on the type of business.
The company wants to keep track of the company net working capital compared to the total assets. If it is high value, it means the company has strong financial health which has enough ability to pay off any financial obligation. However, it also reflects that the company loses its opportunity cost to use their asset to invest. They left a huge part of the capital in the current assets rather than investing for more returns. They will be able to generate more income if they invest in any other investments.
If the ratio is too low, it means the company has utilized most of the capital in the long-term assets. They are seeking the opportunity to expand and grow their business. However, they will face a risk of liquidation if they are unable to generate cash from operations to pay for the business obligation. It will face a high risk of liquidation as most of the assets are not reserved.
Net Working Capital to Total Asset = Net Working Capital / Total Asset
Net Working capital = Current Asset – Current Liability
Base on the company ABC financial statement, we have the following information:
- Current Asset $ 30,000
- Current Liabilities $ 20,000
- Total Assets $ 100,000
Net Working Capital = (30,000 – 20,000)/100,000 = 0.1 = 10%
It means the net working capital of the company is equal to 10% of company total assets. Company spends 10% of the total capital (Equity + Debt) on net working capital. The company has enough ability to use the current assets to pay for the current obligations. In the short term, the company has enough cash to use, it is not necessary to borrow from other parties. It also does not require the company to sell any fixed assets to settle with liability.
Use of This Ratio
This ratio is just one of many financial tools that investors can use to evaluate the company financial health and risk. We cannot absolutely depend on this measurement alone. It is only the indicator which we need to look further into the company operation, financial report and so on.
A high ratio means that the company is able to maintain a high level of current assets compared to current liabilities. The company has enough ability to pay for the supplier, employee, and other expenses. It is due to various reasons such as the high accounts receivable, inventory, or cash in the company balance sheet.
A low ratio shows the company difficulties in using the current asset to settle the current financial obligations. It would be ok if the company has enough ability to generate more cash from its operations. The company can sell the service for additional income and it will help to improve the ratio.
What is a good net working capital to total assets?
There is no optimal level of net working capital to total assets for every company. It depends on the company operation, type of business, level of risk, and management behavior toward risk.
The company has to balance between risk and opportunity. They have to ensure that the company can settle both short-term and long-term liabilities on time. It does not matter how good the investments are, it will be a big problem when the company runs out of cash to pay the suppliers, employees, and creditors. It will force the company to go bankrupt even the company is in a profitable position. Most of the companies liquidate due to a lack of cash rather than operation loss.
The company needs to take the opportunity to make new investments and expand its current operation. The capital that we raise is supposed to invest and generate returns for the shareholders. What is the point of creating the company and keeping all the money in the bank without making any investments? Shareholders expect higher returns from the company comparing to interest from bonds or savings which almost zero risks.
Negative Net working capital to total assets
Net working capital to a total asset can be negative, it happens when the company has negative working capital, current asset less than the current liabilities. It shows that the company is in financial difficulties, they cannot use the current asset to pay for the current liability. Without any further action, it can lead to bankruptcy.
Management needs to look for other cash flow such loan or sell of the investing assets include bonds and shares. It must be done as soon as possible, as the current liabilities will be due in a very short time. We need cash to settle these obligations.