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What is Net Capital?

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  • Written By: Osmand Vitez
  • Edited By: Kristen Osborne
  • Last Modified Date: 31 August 2016
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Net capital is an organization's net worth, commonly calculated by total assets minus total liabilities. A variation on this formula is to deduct assets not easily converted to cash, such as notes receivable or inventory. This removes assets the company may be unable to achieve full value for when selling them during business liquidation. Inventory is a common deduction from net capital because a company may have specific items that have a small market niche for these items.

A secondary definition of net capital is in the financial services industry. Companies acting as brokers or dealers in security investments must maintain specific liquid capital on hand per government requirements. For example, a ratio may be 10 to one, indicating that for every $10 US Dollars (USD) in debt, the brokerage must have $1 USD of liquid assets. Liquid assets are most typically cash and cash equivalents, such as accounts receivable, short-term investments, notes receivable or other items the company can quickly sell to raise cash. Some countries may consider precious like gold and silver as cash equivalents.

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Business stakeholders use net capital to determine how well the company can meet short-term financial obligations. The liability portion of the net capital formula is accounts payable and other short-term obligations the company owes to vendors. These obligations will quickly affect a company’s credit worthiness if left unpaid. Therefore, the company must have the cash to cover these obligations. Two financial ratios that measure a company’s liquidity using net capital information are the current and quick ratios.

The current ratio is current assets divided by current liabilities. For example, a company with $750,000 USD in current assets and $250,000 USD in current liabilities has a current ratio of three. Typically, a current ratio under one means a company has significant trouble meeting its short-term obligations. Another view means that the company has $3 USD in current assets for every $1 USD in current liabilities.

The quick ratio strips inventory out of the current ratio formula. As noted above, companies may be unable to sell the inventory in a short period of time to pay off current liabilities. For example, a company has $750,000 USD in current assets of which $250,000 USD is inventory. With $250,000 in current liabilities, the company’s quick ratio is two, meaning the company now has $2 USD of cash and cash equivalents to pay for each $1 USD in current liabilities. These rations are quite common when reviewing a company’s net capital position.

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BigManCar
Post 3

I prefer to use the quick ratio when I figure out the capital ratio for my business. We do have a lot of money in inventory, but that does not really equate to cash on hand or really any kind of liquid asset.

Our inventory is worth considerable money, but we are a specialized industry and it is not the kind of thing you could sell to just anyone and come up with quick cash, so once it is purchased we do not consider it an asset until we find a buyer.

bigjim
Post 2

@winslo2004 - You are so right about that. I own a business and while we have always been able to pay our bills, there have been a few months where a bit of "shucking and jiving" was required, for sure.

There are months where we will have tens of thousands of dollars owed to us, but we are still tight on meeting our liabilities because the customers are slow in paying. It has gotten worse with the bad economy, but we have always been able to meet payroll so far.

winslo2004
Post 1

Lack of net capital can be a killer for a business, especially a small one. I had no idea how much money moves through a business, even a relatively small one, until I started working for a friend's computer company.

This was not a huge company by any means, just the owner and three employees, but their monthly expenses were almost $30,000 just to keep everything going. That doesn't include net working capital for projects and other tasks where you might buy materials and do the work weeks or months before you get paid for it.

You hear that so many businesses fail in their first few years, This is a big part of the reason why. They just run out of money and can't pay people, even if they have a lot of customers.

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