If you’re a contractor, you probably have several different metrics you use to gauge business performance. For instance, you may focus on project size or growing your business by securing larger and larger bids.
However, these metrics can be misleading, and net working capital is a better benchmark to measure the health of your business. That’s because you can still run out of money even if you continue landing larger projects.
Net working capital measures short-term liquidity and can help you evaluate whether or not your company is using its assets efficiently. By focusing on net working capital, you’ll ensure your company grows sustainably and doesn’t go out of business.
What is net working capital?
Net working capital is the difference between a company’s current assets and liabilities. It’s a way to measure a business’s short-term liquidity — it looks at your current (or liquid) assets and your current (or short-term) liabilities.
Current assets include things like:
- Customer payments (receivables from pending invoices)
- Any other assets that can be converted to cash in less than a year
Current liabilities include:
- Employee wages
- Payments to vendors or suppliers
- Credit card debt or other short-term debt obligations
The net working capital formula is: Net working capital = Current assets - current liabilities. Or to put it in more practical terms, you might calculate your company’s net working capital ratio by subtracting your total debt from the current cash on hand.
Why net working capital is important for contractors
Knowing your net working capital and how it changes over time is key to ensuring you can always cover your financial obligations and fund business operations. Here are four reasons why net working capital is an essential metric for contractors:
- Ensures day-to-day operations run smoothly: Your net working capital ratio helps you measure your business’s liquidity and determine whether it has money to cover short-term business expenses. The larger your company’s net working capital, the more prepared it is to cover its financial obligations. It can be helpful to track your net working capital over time to see whether this trend is improving or declining.
- Everything is paid for upfront: You have the money available to meet current business obligations when your business has sufficient net working capital. This means you can pay employees and vendors on time and have the resources to stay on top of your current projects.
- It’s used to determine creditworthiness: Net working capital is one metric banks will use to assess creditworthiness. Higher net working capital indicates your company is in a good financial situation, which can improve your business credit score.
- Prevents your company from becoming insolvent: Without adequate working capital, your company can become insolvent even if it’s growing quickly. Most contractors experience a gap between when they take on new work and when they get paid. Poor net working capital can lead to serious cash flow problems.
How to improve net working capital
Improving net working capital is the best way to measure your company’s liquidity and ensure it’s growing sustainably. If your net working capital isn’t where you want it to be, here are seven steps you can take to start improving it:
- Take on a variety of project sizes: It’s a good idea to take on a variety of large and small projects. Having a mix of different project sizes can balance your need for cash right now while you work on securing the bigger ones that help your business grow.
- Stay on top of overdue payments: One of the best ways to improve your net working capital is by ensuring that customers pay on time. Follow up with customers as soon as an invoice is due and consider charging late fees for seriously overdue invoices.
- Adjust your payment terms: Another option is to adjust your payment terms for vendors and clients. See if you can lengthen your payment terms for vendors if they’ll allow it without charging you a late fee. Meanwhile, you want to try to shorten the billing cycle for customers so you can collect outstanding invoices as soon as possible.
- Utilize early payment discounts: Some vendors will offer discounts for paying your invoice early. For instance, an early payment discount of 2/10 means you can save 2% on your invoice if you pay within 10 days. This discount can be a great way to reduce your accounts payable and save a little bit of cash.
- Return unused inventory: You may be able to return unused inventory to your suppliers in exchange for a restocking fee. Doing this can ensure you’re using your resources efficiently and don’t have a lot of unused inventory on hand.
- Keep a line of credit: The best time to take out a line of credit is before you actually need it. If you wait until your business is in a difficult financial position, you’ll have fewer options available. If you can afford it, maintain a line of credit to ensure you don’t face a cash crunch and end up stuck with a high-interest loan.
- Use a 30-day charge card: And finally, using a 30-day charge card for project expenses can help you improve your net working capital. You can borrow money interest-free and repay your balance within 30 days with a charge card. A charge card can help you free up cash flow, fund current projects, and accelerate your business growth.
The bottom line
Net working capital is one of the most critical metrics contractors can use to gauge the financial strength of their business. Without adequate working capital, you could miss out on new business opportunities and even go out of business.
If you’re looking for ways to improve your net working capital, Toolbox can help. You can apply for a charge card without giving a personal guarantee. The application process is easy, and you could be approved within 24 hours.