Is it difficult for your business to pay its present debts? If so, what are you doing? Taking action may be the only way to save the situation. Reduce liabilities and raise current assets by optimizing your processes to obtain a market edge with a positive net working capital ratio. Net working capital (NWC) is a measure of a company’s short-term liquidity. For short-term financial commitments, emergencies, and investments in creativity and development, you’ll be able to access the funds you require. Basically, accounting and finance consultants make use of the net working capital formula to keep tabs on their companies’ current assets and liabilities. As a result, they will be able to make sure that obligations are met while also leaving money on hand to cover both emergency and unanticipated market opportunities. This article details, with examples, everything you need to know about working capital.
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What Is Net Working Capital?
Net Working Capital (NWC) is the balance sheet difference between a company’s current assets and current liabilities. Sometimes shortened as “working capital,” it is the amount remaining after subtracting a company’s current liabilities (accounts payable and debts) from its current assets (cash, accounts receivable/customers’ outstanding bills, and inventories of raw materials and completed items)
It denotes the Liquidity ratios used to assess a company’s capacity to pay short-term debts and support day-to-day operations. Generally, the ideal situation is to have a positive net working capital balance, which means you have more current assets than current liabilities.
In addition, it serves as a short-term indicator of the financial strength, operational efficiency, and liquidity of an organization. Normally, investing and expanding should be possible if a company has a significant positive NWC. However, with current obligations or liabilities exceeding current assets, such a company may struggle to grow or repay investors. Hence, Bankruptcy may become a real possibility.
Positive Working Capital
Basically, this implies that your company is able to satisfy its current financial responsibilities and has additional cash available for investment, operational development or expansion, innovation, and crises among others.
Negative Net Working Capital
It is a sign that your firm may need financing or investment in order to continue operations and maintain its financial viability. This is due to your firm’s inability to pay its current debts.
Net Zero Working capital
This shows that the corporation has enough liquidity to satisfy its obligations, but not enough to invest, expand, etc.
Generally, current assets and current liabilities drive the NWC financial model used to anticipate the company’s future cash needs. The following are, however, some of what a company can have as either current assets or current liabilities;
Current Assets
These are assets such as cash and items that can be transformed into liquid assets over the next 12 months. These may include the following:
- Cash and cash equivalents.
- Money market funds.
- Treasury bills
- Inventory
- Accounts receivable
- Investments
- Short-term government bonds.
- Marketable securities
- Prepaid expenses.
Current Liabilities
The top of the balance sheet shows current liabilities, which are monies a firm must pay within a year. Here are a few of them:
- Accounts payable (monies you’re owing suppliers)
- Credit card balances
- Amounts due on short-term business loans, such as a line of credit,
- A bank account.
- Income tax liabilities
- Payroll liabilities
- Temporary credit lines.
- Debts owed in international trade.
- Customer feedback.
- Long-term debt
What Is the Net Working Capital Formula?
The usual formula for calculating net working capital is:
- NWC = Current Assets – Current Liabilities
However, there are a variety of ways or approaches to using the formula to calculate the net working capital. In some cases, analysts will eliminate cash and outstanding debt from the equation. Or, in another instance, just include inventory, accounts receivable, and accounts payable in the equation. Hence, here is how the NWC formula might look:
- NWC = Current Assets (less cash) – Current Liabilities (less debt)
- NWC = Accounts Receivable + Inventory – Accounts Payable
Accordingly, analysts are able to assess different aspects of the company’s financial health by altering the net working capital formula. Nevertheless, most people prefer to use the first formula when determining the net working capital of a business.
How to Calculate Net Working Capital
You can use the basic formula above to measure the company’s current assets against its current liabilities in order to arrive at net working capital.
#1. Calculate the Company’s Current Assets
Normally, the balance sheet should include Items such as accounts receivable, inventory as well as cash. The term “current assets” refers to assets that can be sold within a year.
#2. Calculate Company’s Current Liabilities
Recognize your current financial obligations and make an accurate assessment of your exposure. These will be included on the balance sheet as well, just like the assets. Typically, current liabilities are any obligations that you must meet within the next 12 months. This may include loan repayments and unpaid taxes, which are considered current liabilities. You can also find worker salaries and accounts payable in liabilities for this period of the year.
#3. Subtract Current Liabilities From Current Assets Using the Net Working Capital Formula.
Looking at the various examples of net working capital;
- A company with current assets of $150,000 and current liabilities of $95,000 would have net working capital of $55,000.
What Is Net Working Capital Ratio?
The net working capital ratio is a calculation that compares a company’s current assets to its short-term liabilities. The NWC ratio, like net working capital, can be used to see if you have enough current assets to meet your current liabilities.
The following formula can be used to calculate the net working capital ratio:
(Assets in Use) / (Current Liabilities)
Generally, you can find the ideal net working capital ratio between 1.2 and 2.0. Whatever or anything else greater than this could hypothetically mean a corporation isn’t getting the most out of its current assets. However, liquidity ratios like the quick ratio and current ratio can enable the company to manage its short-term assets. Likewise, these measures are also scrutinized by lenders throughout the loan application process.
Examples of Working Capital
To foster more understanding of how the working capital works, let’s look at some examples. In these below examples, we’ll be considering the case of a fantasy firm “AB Company ” and its attempts to properly track and monitor its liquidity in an attempt to fully understand how to utilize the NWC, and changes in NWC, as well as the net working capital ratio.
AB Company has the following current assets:
- Cash and cash equivalents totaled $850,000.
- Accounts receivable balance $90,000
- Inventory $250,000.
Likewise, it has the following on the other section of the balance sheet:
- A $600,000 short-term loan
- A $95,000 accounts payable balance
- Liabilities totaling $70,800
You will get the following results if you properly input these numbers into net working capital calculator and formula:
- Total current assets: $850,000 + $90,000 + $250,000 = $1,190,000.
- Total current liabilities: $600,000 + $95,000 + $70,800 = $765,800.
Hence, we can use these totals to determine NWC:
- $1,190,000 − $765,800= $424,200
The AB company has a $424,200 NWC balance. This is a significant improvement from last year’s NWC balance which stands at $180,000 ($980,000 – $800,000).
Let’s try to put this number into emphasis by inserting it into the net working capital ratio formula;
- $1,190,000 divided by $765,800 equals 1.55
The current ratio is substantially better than the NWC ratio from the prior year, which was:
- $980,000 divided by $800,000 equals 1.23
From the above examples and calculations, AB Company appears to have a strong net working capital ratio and is therefore making good use of its present assets. Especially when we compare it to the previous year when there is a slip in the NWC ratio barely below the optimal range. And as a result, putting the company at risk of not being able to cover its short-term loans.
Nevertheless, based on the nature of their business, it may be necessary to track their inventories in an effort to avoid wasting money on assets that will deteriorate before they can be liquidated or perhaps turned into cash.
Why Is Net Working Capital Important?
Generally, net working capital is important for several reasons. Nevertheless, the most significant of these reasons is that it conveys a sense of a company’s ability to meet short-term obligations. Basically, businesses with zero or more working capital, are able to meet their existing obligations. However, a company’s ability to meet its short-term obligations is largely dependent on the amount of NWC it has. Regardless, businesses should always be able to afford to pay all of their expenses for a year at a time.
In addition, you can always use net working capital to see how your cash flow report is increasing or decreasing over time by comparing how the statistic changes over time. If the NWC of your company is significantly positive, this is a strong sign that you will be able to meet your future financial obligations. Meanwhile, if it’s significantly negative, it indicates that your business is in danger of bankruptcy and cannot meet its forthcoming obligations.
Likewise, a company’s ability to expand fast can be gauged by the amount of net working capital it has. If a company has much cash on hand, it may be able to quickly expand its operations, for example, by purchasing more efficient machinery.
How To Improve Net Working Capital
Generally, if your NWC is not as high as you would like it to be, you can choose to enhance it. How? Basically, you can do that by making some operational improvements. Take the following steps into consideration:
- As soon as an invoice is due, contact your customers so that you can collect late payments more quickly.
- Shorten the billing cycle by modifying the payment terms to get paid more frequently.
- Lengthen the time it takes for vendors to get paid as long as they won’t charge you late penalties.
- To receive a refund, you must return any unused inventory to your suppliers in a timely way.
- Investigate more cost-effective techniques for reordering inventory.
Bottom Line
Net working capital evaluates and provides a fast look at the ability of a company to meet its present financial commitments or short-term obligations. Positive NWC indicates that the short-term assets of a company are sufficient for debt repayment and investment in the company’s future. Meanwhile, you can increase your NWC by refinancing high-interest debt into longer-term and lower-interest financing and also by liquidating outdated equipment that is still functional.
In addition, tracking changes that occur over a period of time can provide a longer-term picture of financial well-being. For organizations, tracking changes in this ratio provides a means to monitor good and negative trends.
On the contrary, a decrease in working capital due to new initiatives or investments can also be a sign of a decrease in sales or an increase in overhead expenditures. As a result, you should begin your research into efficiency by calculating the change in NWC.
NWC FAQs
How can you reduce net working capital ?
Among many available options, one is to require customers to pay within a shorter time frame. However, when dealing with large, influential clients, this might be a challenge. Consider returning unused products to suppliers in exchange for a restocking fee, too. Meanwhile, it’s best to extend the payment period if you’re able to give a large number of purchases in exchange.
Is working capital the same thing as net working capital?
Yes. NWC when shortened is referred to as working capital and it is the difference between a firm’s current assets and current liabilities.
What are net working problems?
For these reasons, the net working capital figure might be exceedingly misleading.
- The Effects of a Credit Line
- Anomalies at the time of measurement
- Liquidity does not apply to all assets.
Related Articles
- Liquidity Ratio: Types, Formulas and Calculations
- Financial Performance: A Comprehensive Guide For Any Business(+ quick tools)
- Balance Sheet vs. Income Statement: Examples, Differences & Relationship
- Cash Ratio: Formula, Calculations & Examples
- WORKING CAPITAL: Definition & Tips For Effective Management
