Net capital is a term that describes the net worth of an organization.
Capital is the net worth of an organization, usually calculated as total assets minus total liabilities. A variation of this formula is to deduct assets that are not easily converted to cash, such as notes receivable or inventory. This eliminates assets that the business cannot reach at full value by selling them during the liquidation of the business. Inventory is a common deduction from capital because a business may have specific items that have a small market niche for those items.
A secondary definition of net worth is found in the financial services industry. Firms acting as securities investment brokers or dealers must keep specified liquid capital available in accordance with government requirements. For example, a ratio could 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 usually cash and cash equivalents, such as accounts receivable, short-term investments, notes receivable, or other items that the business can sell quickly for cash. Some countries may consider valuables such as gold and silver as cash equivalents.
The company’s stakeholders use net worth to determine how well the company can meet short-term financial obligations. The liability portion of the net worth formula is accounts payable and other short-term obligations the business owes to vendors. These obligations will quickly affect a company’s solvency if they are not paid. Therefore, the company must have cash to cover these obligations. Two financial ratios that measure a company’s liquidity using net worth information are the current and flash ratios.
The current ratio is current assets divided by current liabilities. For example, a company with $750,000 in current assets and $250,000 in current liabilities has a current ratio of three. Generally, a current ratio of less than one means that the company has significant problems meeting its short-term obligations. Another view means that the company has $3 in current assets for every $1 in current liabilities.
The immediate liquidity ratio removes stocks from the current ratio formula. As noted above, companies may not be able to sell inventory in a short period of time to pay off current liabilities. For example, a company has $750,000 in current assets, of which $250,000 is inventory. With $250,000 in current liabilities, the firm’s immediate liquidity ratio is two, meaning the firm now has $2 in cash and cash equivalents to pay for every $1 in current liabilities. These ratios are quite common when reviewing a company’s net worth position.