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Net Working Capital is the money a company has left over after all of its expenses are paid and before any capital investments have been made. This can be in cash, receivables or payables. In business, having an understanding of NWC helps companies to understand their liquidity position at different stages of their life cycle.
The gap between a company’s Assets in Use and Liabilities in the Present is known as net working capital (NWC). A corporation with a positive net working capital has enough money to satisfy its existing financial commitments and engage in additional operations. The NWC is $45,000 if Assets in Use are $85,000 and Liabilities in the Present are $40,000.
The formula for Net Working Capital
Calculating a company’s net working capital is quite straightforward. We’ll teach you how to use the formula below.
The formula for calculating net working capital (NWC) is as follows:
(Cash and Cash Equivalents) + (Marketable Investments) + (Trade Accounts Receivable) + (Inventory) – (Net Working Capital) (Trade Accounts Payable)
– OR –
(Assets in Use – Net Working Capital) (Liabilities in the Present)
Example of Net Working Capital
Let’s go down each component of net working capital now that you’ve grasped the equation. This will assist you in determining your Assets in Use, Liabilities in the Present, and total net working capital.
Assets in Use
Assets in Use are short-term assets found on your balance sheet that can be converted to cash within 1 year or less. Assets in Use typically include cash and cash equivalents such as treasury bills, short-term government bonds, commercial paper, and money market funds. Marketable securities, accounts receivables, and inventories are also considered Assets in Use.
For example, your company has cash equivalents of $50,000, accounts receivable of $5,000, and total inventories worth $10,000. To calculate the total Assets in Use, you simply sum these values together:
$50,000 plus $5,000 plus $10,000 equals $65,000.
Liabilities in the Present
Liabilities in the Present are short-term financial obligations due in 1 year or less. Liabilities in the Present usually include short-term loans, lines of credit, accounts payable, accrued liabilities, and other debts such as credit cards, trade debts, and vendor notes. Current portions of long-term debt-like commercial real estate loans and small business loans are also considered Liabilities in the Present.
For example, your company has a $20,000 short-term loan, accounts payable of $7,000, and accrued liabilities of $4,000. To calculate the total Liabilities in the Present, you need to add all these values individual current liability numbers:
$20,000 plus $7,000 plus $4,000 equals $31,000.
Now that you have the values for both Assets in Use and Liabilities in the Present, the next step is to subtract the Liabilities in the Present from the Assets in Use to get the value of your net working capital. Using the above figures, the calculation is as follows:
NWC = $65,000 – $31,000 = $34,000
What Is the Importance of Net Working Capital?
NWC is significant since it reflects your short-term company assets that may be used to settle short-term debts and engage in revenue-generating activities. It may be a useful measure of how effectively a company is running and how financially sound it is in the near term.
A positive net working capital, for example, indicates that a firm has sufficient short-term liquidity to meet present commitments while still investing in future development. A firm with net-zero working capital can only satisfy its present financial commitments, whereas a company with negative net working capital will likely need to borrow or raise money to be viable.
Net Working Capital Variations
Net Working Capital Variations is a measure of operating cash flow (OCF) and is typically recorded on your statement of cash flows. The change in net working capital can show you if your short-term business assets are increasing or decreasing in relation to your short-term liabilities from one period to the next.
Increasing or decreasing net working capital, on the other hand, isn’t always a negative thing. In certain cases, strategic company actions need a near-term rise in short-term liabilities. Increasing net working capital might also indicate that more of your money is invested in assets that aren’t as liquid. It’s critical to keep track of changes in net working capital in order to keep an eye on your operational cash flow.
You may use the following formula to calculate the change:
(Current Net Working Capital) – (Current Net Working Capital) – (Current Net Working Capital (Previous Net Working Capital)
The ratio of Net Working Capital to Total Assets
The net working capital (NWC) ratio measures the percentage of a company’s Assets in Use to its short-term liabilities. Similar to net working capital, the NWC ratio can be used to determine whether or not you have enough Assets in Use to cover your Liabilities in the Present.
The Ratio of Net Working Capital to Total Assets can be calculated as follows:
(Assets in Use) / (Liabilities in the Present)
The optimal ratio is to have between 1.2 – 2 times the amount of Assets in Use to Liabilities in the Present. Anything higher could indicate that a company isn’t making good use of its Assets in Use. Liquidity measures such as the quick ratio and the working capital ratio can help a company with its short-term asset management.
The Benefits and Drawbacks of Net Working Capital
Net working capital is an important metric for determining your company’s short-term liquidity. It shows if your business has adequate working capital to pay its present financial commitments while also investing in its future development.
The Benefits of Net Working Capital
- You can satisfy your existing financial commitments if you have positive net working capital.
- If you have a positive net working capital, you may invest in other operational requirements.
Net Working Capital’s Drawbacks:
- Too much might indicate that your company isn’t making the most use of its short-term assets.
- Net working capital does not always provide an accurate liquidity measure because some Assets in Use can’t be easily converted to cash.
How to Boost Your Net Working Capital (NWC)
There is a slew of options for increasing your net working capital. Selling long-term assets for cash, boosting inventory turnover, and refinancing short-term obligations with long-term debts are just a few examples. These actions will aid in improving your company’s short-term liquidity.
Here are three strategies for increasing your net working capital (NWC):
1. Make a cash sale of long-term assets
Long-term assets such as equipment and machinery are not considered Assets in Use. If your company has unused long-term assets like old office equipment, consider selling them for cash. This will increase your NWC since cash is a current asset while equipment is a long-term asset and isn’t included in the NWC formula.
2. Make Inventory Turnover Higher
Take time to review your inventory and find ways to increase your inventory turnover so you don’t become overstocked. While inventory is a current asset, it’s not as liquid as cash and you can typically sell your inventory for a premium. For example, if your inventory is worth $1,000 but you are able to sell it for $1,500 in cash, your Assets in Use will increase by $500.
3. Combine short-term and long-term debt.
Short-term debts are Liabilities in the Present due in 1 year or less. When you refinance short-term debt with long-term debt, it will no longer be included in the calculation of your NWC, aside from the total portion of principal due in one year. This will help increase your NWC by lowering your Liabilities in the Present.
Conclusion
Net working capital measures a company’s ability to meet its current financial obligations. When a company has a positive net working capital, it means that it has enough short-term assets to finance to pay its short-term debts and even invest in its growth. Companies can increase their net working capital by increasing their Assets in Use and decreasing their short-term liabilities.
