Net working capital is a core metric used to monitor a company’s financial health.
In this FAQ we will cover what net working capital is, why it is important, and how it is calculated in a business.
What Is Net Working Capital?
Net working capital refers to the difference between a business’s current assets and liabilities. This metric is used to measure the liquidity of a business and indicates short-term financial strength. The higher the net working capital is, the more solvent or liquid the business is. Conversely, if net working capital is negative then it is an indication that the business is not liquid and may face challenges when trying to grow.
While the term is often used to measure liquidity, it can also be used to measure operational efficiency. When calculating net working capital, many analysts check to see if it is too high, or too low. By doing this, they can see the extent to which the business is managing its inventory, receivables, and vendors.
Why Net Working Capital Is Important
Like all financial metrics, net working capital is most effectively interpreted over time. Checking trends helps us to understand the fuller story. In general, analysts are looking for positive net working capital without it being excessive.
Net Working Capital as An Indicator of Liquidity
Since net working capital is the difference between assets and liabilities, it essentially reflects a business’s ability to use its assets to cover its liabilities. By removing long-term assets and liabilities, it is a good indicator as to whether a business can sustain itself and can remain financially solvent in the short term (that is liquid). Conversely, the metric can show whether its short-term liabilities are hindering the business’s ability to grow.
Net Working Capital as An Indicator of Efficiency
Where net working capital is negative, it may indicate that the business is not managing its vendor and customer payments in an orderly manner. In particular, the time it takes collecting dues from your customers might be taking too long.
On the opposite end of the spectrum, when net working capital is excessive it is an indication that the business is not managing its cash and short-term assets effectively. When this happens, it means that a business has either excessive cash, receivables, prepaid expenses, or inventories.
Limitations Of Net Working Capital
One of the common limitations of net working capital is that the calculation is agnostic to cash flow, which is a major component in being able to service debt. If the business has a large line of credit, it might negatively impact net working capital, despite the business having ample cash flow to service the debt.
In addition, not all current assets are liquid. For example, certain raw materials and inventory might not be easily converted to cash. Similarly, receivables are not always easily collected and in certain cases are not collectible at all.
Net Working Capital Formula
How To Calculate Net Working Capital?
The formula for calculating net working capital is simple, but it is important to only include current assets and liabilities. Below is a breakdown of the assets and liabilities typically used in the calculation. The general rule is that receivables and payables with a timeframe of fewer than twelve months are considered “current”.
● Cash and cash equivalents
● Marketable investments
● Accounts Receivable
● Prepaid Expenses
● Raw Materials
● Accounts Payable
● Accrued Expenses
● Short-term debt
The formula for calculating net working capital is:
NWC = Current Assets – Current Liabilities
Net working capital should be regularly calculated and monitored regularly to assess both liquidity and efficiency over time.
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