In commercial real estate financing, it’s important to have an idea of your working capital, also known as net working capital (NWC), to understand the viability of your investments and real estate properties. Net working capital can help you assess how well your business is doing, whether there’s potential for growth, and whether or not you’re at financial risk.
What Is Net Working Capital (NWC)?
Working capital, or net working capital (NWC), is the difference between a company’s current assets and its current liabilities, which can be found on a balance sheet.
Current assets include everything a company currently owns, such as cash, customers’ unpaid bills (also known as accounts receivable), and inventory of goods and materials. Current liabilities are any money borrowed or owed, also called accounts payable.
A company’s net working capital is essentially a measure of its liquidity, efficiency, and financial well-being. If the working capital is high, then the company has potential to grow, but if the company has more current liabilities than current assets, then it could be at risk of going bankrupt. Essentially, working capital shows a company’s ability to pay off its current liabilities with its current assets.
“Working capital allows a real estate group to know where they stand financially at a moment in time,” said Jonathan Fishman, co-founder of Bizydev, a company that works with other companies to help them grow their business in the marketplace.
“Having working capital is a look at available cash flow,” continued Fishman. Fishman added that there’s no such thing as a “perfect amount of working capital,” but rather, the right amount depends on factors like what you intend to manage and operate, and what constitutes a comfortable cash position for you in the short-term and the long-term. You can use this figure to compare financials year-over-year (YOY) to ensure you’re making a profit.
How to Calculate Working Capital in Real Estate
Working capital is calculated by taking a company’s current liabilities and subtracting them from its current assets. Therefore, the working capital formula looks like this:
- Current Assets – Current Liabilities = Working Capital
Assets are everything a company owns that can be turned into cash within one year. A company’s ability to turn assets into cash is called liquidity. Some examples include:
- Cash and cash equivalents
- Equity and debt securities that can be liquidated (marketable securities)
- Accounts receivable
- Inventory, or goods available for sale
- Prepaid expenses such as insurance or rent (anything that has already been paid for)
- Company investments
- Fixed assets such as land, machinery, buildings, etc.
- Intangible assets like intellectual property
All these assets should be easily viewable on your balance sheet.
Liabilities include everything a company owes, like mortgage payments, interest, employee salaries, rent, utilities, and taxes. These are all the debts and expenses a company expects to pay in the short-term or within the next year, hence the term accounts payable.
Fishman also noted that it’s important to account for unplanned liabilities. For instance, Fishman said, an unplanned expense could be that there’s a faulty pipe in the building that requires plumbing work. This becomes a liability, or money owed.
“When you talk about working capital, you have to use what you know, and what could happen — or what, in essence, you don’t know,” said Fishman. “And that’s the art of managing cash flow.”
Another working capital calculation and liquidity ratio includes the “current ratio,” which is current assets divided by current liabilities. If the ratio is above 1, then the assets exceed the liabilities. The higher the ratio, the better this is for company finances.
How Changes in Working Capital Affect Your Cash Flow
Working capital can change every day, depending on the debt and expenses a person or company takes on. When embarking on new projects, such as the purchase of more land or the construction of new buildings, this lowers your working capital and reduces cash flow. However, that expansion in property could lead to increased working capital and cash flow long-term.
In addition to your balance sheet which includes accounts receivable and payable, some companies keep a cash flow statement, as well. A cash flow statement will give you a good look at your liquidity.
An Example of the Working Capital Formula in Real Estate
When investing in commercial real estate and accounting for working capital, first and foremost, “it’s always good to have a budget,” said Fishman. Your budget should account for at least a 12-month period of time, in which you list your assets and liabilities for the next year, taking into account those unplanned liabilities.
“What’s likely going to happen under different scenarios at the property?” Fishman said, as a reminder to think of all financial possibilities.
“If you could forecast to the best of your ability the income, the expenses, the anticipated versus unanticipated capital costs of the project or property, then that gets you to a number that you need to have available,” said Fishman. “Planning is a key element for working capital so you know what to expect.”
With a retail property, for instance, you need to budget for the coming year by knowing your current assets and liabilities, and accounting for unplanned liabilities like thefts or property damage. By calculating a projected working capital based on these numbers, your business is more likely to run smoothly in the coming year.
Finally, said Fishman, “You need to have different strategies that you could implement should your working capital not be sufficient.”
Those strategies would involve seeking out additional cash flow through loans, perhaps, which would again affect your working capital as far as debt goes.
Working Capital Can Determine the Well-Being of Your Investment
Calculating and understanding working capital is an essential part of real estate investment. Your working capital gives an idea of your investment’s cash flow and financial well-being, and so it’s important to budget and plan to ensure a healthy NWC. And always make sure to account for unexpected expenses and liabilities so that your company and investments are prepared for the worst.