Net Working Capital (NWC): Definition, Formula, Examples, types

Net Working capital

 

If a business owner wants the company to function seamlessly its major task is to keep the eye on the Net Working capital. 

 

Now,

what is Net Working Capital?

 

It is the difference between a company’s current assets and current liabilities. When a company derives positive networking capital this clearly means that the company has enough funds to take care of the financial needs or obligations. Also, a positive working capital helps the business owner to forecast their future and make wise investment choices.

It is also known as Working Capital. It is the money or assets which a company needs to defend for its short-term expenses. These short-term expenses include day-to-day requirements, cash, short-term debt, raw material, and many more.

It is also used to measure the short-term liquidity of the business. 

Net working capital is calculated using the line items from a business’s balance sheet. Working capital is a company’s liquidities measure and the ability through which the company can go up with short-term obligations and fund operations of the business. The larger the networking capital of a company the more likely it is that the company will be able to finance its short-term expenses and debt obligations.

 

As already mentioned the term refers to the difference between the company’s current assets and current liabilities on the balance sheet.

 

  • Items such as cash, account receivable, and inventory items are included in current assets.
  • Outstanding debts like accounts payable and accrued expenses refer to current liabilities.

Also Read, CUSTOMER ACQUISITION AND RETENTION STRATEGIES (FULL GUIDE)

 

Types of Net Working Capital

The types of working capital depend on which view a company intends to take. There are two ways a company can do this:

  • Balance sheet view
  • Operating cycle view

 

  • Balance Sheet View

If a company opts for a balance sheet, then the company will most probably define working capital as net working capital (NWC) and gross working capital. Net working capital is the difference between current assets and current liabilities whereas gross working capital is just the current assets in the balance sheet.

  • Operating Cycle View

If a company opts for an operating cycle view, then the working capital is classified into:

  1. Temporary working capital
  2. Permanent working capital

 

Temporary Working Capital: It’s the difference between net working capital and permanent working capital. 

 

Permanent Working Capital: Permanent working capital works for the fixed assets of the company.

 

Why is net working capital significant?

Net working capital is important because it indicates the liquidity position of a company. A company’s liquidity is an excellent sign of how a company is growing as it indicates the liquidity position of the company and we get to know where the company is and we get to know where the company stands.

While reading the previous record and comparing it to the current year records and in the different economic conditions, it will be visible how the company’s liquidity has fared against these testing conditions and how has it grown in line with it. Negative working capital means that the company owes more than it owns which clearly means that it is at a loss.

The prolonged negative net working capital condition turns out to be bad for the company.

Important points to be considered about the net working capital are that it is instrumental to maintaining a company’s cash flow.

If the company is too slow in retrieving pending money from the customers or any asset that is yet to be released, there can be a dip in the company’s cash flow. Therefore the company’s cash flow can be used to boost its working capital for investment in projects.

 

Net working capital formula?

Net working capital tells us about financial health and short-term financial health.

Two items that are always there in the balance sheet of any company, listed or unlisted are namely current assets and current liabilities.  Current assets are those assets that can be converted easily into cash and have the ability to be converted in a year. Whereas current liabilities are those debt obligations that need to be paid off within a year.

Also, Read Minimum Viable Product: Definition, Meaning, Examples, Types

 

Components of Net Working Capital

Since working capital calculation includes current assets and current liabilities, we have to look after the business transactions that fall under these two parameters. 

 

What are current assets?

What are Current assets

Current assets are there that can easily be liquefied into cash. Companies generally follow a timeline of one year. Therefore those assets that can be converted into cash within a year fall under the current assets category.

Some examples of current assets in India are:

  • Cash and cash equivalents
  • Account receivables
  • Inventory
  • Marketable securities
  • Prepaid expenses
  • Any other assets that qualify

  • Cash equivalents- They are financial instruments that can be immediately converted into cash. For example, a bank cheque is a cash equivalent as it is a financial instrument that can immediately be converted into cash.
  • Account receivables- The money that the company is due to receive within a year—products sold to customers on credit, services rendered on credit, etc.
  • Inventory- Goods that are by a company in its business. These are considered as current assets.
  • Marketable securities- It includes treasury bills, short-term deposits, and other money market instruments that have a maturity period of up to one year.

 

What are current liabilities?  

The debt obligations that a company owes and are expected to be paid back within a year are known as current liabilities. These debts can be short-term or old, long term but if due within a year the company needs to pay for it.

The current liabilities comprises of:

  • Notes payable
  • Accounts payable
  • Short term loan
  • Accrued expense
  • Current portion of long term debts

 

  • Notes Payable- It is any amount a company owes to its creditors within a short period.
  • Accounts Payable- It is the money a company has to pay to its suppliers or manufacturers when it buys goods on credit.
  • Short Term loans- These are the loans where the maturity period is up to one year and are used for short-term obligations.
  • Accrued Expenses- These are expenses for which the payment is still due.
  • Current Portion of Long Term Debts- Long-term loans like principal payments or interest payments and any other short-term payable expenses which have any short-term obligations.

 

How to calculate the net working capital?

To calculate net working capital, these steps are to be followed:

  • Addition of Current Assets

Firstly, all the current asset line items are to be added up from the balance sheet. Items include cash and cash equivalents, investments, and accounts receivable.

 

  •  Addition of Current Liabilities

Secondly, all the current liability line items reported on the balance sheet are to be added. These items include account payable, sales tax payable, interest payable, and payroll.

 

  •  Calculation of Net Working Capital

Now subtract current liabilities from current assets. The output that is the final figure is net working capital of the business. This final figure gives you your business’s net working capital.

 

Net Working Capital Formula

The formula for calculating net working capital is:

 

Net Working Capital = Current Assets Current Liabilities

 

 This offers a quick and simple way to check a company’s operational efficiency, financial health and liquidity.

An alternate method  to calculate Net Working Capital is:

 

NWC = Accounts Receivable + Inventory (assets) – Accounts Payable (liability)

Understanding how to calculate net working capital with an example.

When a company has the following Current Assets (CAS) and Current Liabilities (CLs) in its balance sheet.

  • Inventories – Rs.40,000
  • Accounts receivables – Rs.50,000
  • Cash – Rs.10,000
  • Debtors – Rs.5,000
  • Creditors Rs.10,000
  • Short-term loans – Rs.30,000
  • Income Tax Rs.5,000

Net working capital will be calculated as follows –

NWC = CA – CL

= (Inventories + accounts receivables +

Debtors – cash) – (Short-term loans +

Income Tax Creditors)

= (40,000 + 50,000 + 5,000 – 10,000) –

(30,000 + 5,000 – 10,000)

= 95,000 – 25,000

= Rs.70,000

The company has an amount that can sufficiently meet the short-term liabilities as the company’s net working capital is Rs.70,000.

 

The net working capital ratio 

It is the net amount of all elements of working capital.  It reveals whether a business has a sufficient amount of net funds available in the short term to stay in operation or not. 

The following formula can calculate the net working ratio :

 

Current assets Current liabilities = net working capital ratio

 

 A general idea of the liquidity of a business is provided by this measurement, for the following reasons:

 

  • It does not show any relation between the total amount of negative or positive outcome to the amount of current liabilities to be paid off.

 

  • The comparison between the timing of when current assets are to be liquidated to the timing of when current liabilities must be paid off is not done by this. Thus, a positive net working capital ratio can be generated in a situation where there is not sufficient immediate liquidity in current assets to pay off the immediate requirements of current liabilities.

 

  • If the ratio of current assets to liabilities is 1 or higher, the net working capital is positive.
  • If the ratio is less than 1, the net working capital is negative.

 

The business can be grown and the money can be invested if a company has positive working capital. However, when the net working capital is negative it is an indication that it is in debt.

 

Alternative Version of the Net Working Capital Ratio

 

An alternative version of the ratio compares the total amount of assets on the balance sheet to the net working capital. In this case, the formula is:

 

(Current assets – Current liabilities) ÷ Total assets

 

Under the version, the goal is to track the proportion of short-term net funds to assets, on a trend line. By doing so, you can tell if a business is gradually shifting more of its assets into or out of long-term assets, such as fixed assets.The business minimizes its investment in fixed assets and keeps its acids preserved as liquid as possible this helps in increasing the ratio which is considered to be good.

 

Change in the net working capital

Change in the net working capital is the change in working capital of the company from the one accounting period when it is compared with the other accounting period. It is calculated to make sure that sufficient working capital is maintained by the company in every accounting period so that there should not be a shortage of any funds shortly.

 

Formula

Changes in Net Working Capital = Working Capital (Current Year) – Working Capital (Previous Year)

 

Or

 

Change in a Net Working Capital = Change in Current Assets

 – Change in Current Liabilities.

 

How can Changes in Net Working Capital be calculated? 

 

To find the Current Assets for the current year and previous year.

 

We consider the below-mentioned points as current assets:

  • Inventory
  • Accounts Receivable
  • Prepaid Expenses

 

In order to find the Current Liability for the Current Year and Previous Year

 

We consider the below-mentioned following as current liabilities:

 

  • Accounts Payable & Accrued Expenses
  • Interest Payable
  • Deferred Revenue

 

To find Working Capital for the Current Year and Previous Year

 

Working Capital (Current Year) = Current Assets (current year) – Current Liabilities (current year)

 

Working Capital (Previous Year) = Current Assets (previous year) – Current Liabilities (previous year)

 

Example

Now if we calculate the Working Capital for Colgate.

 

Working Capital (2016)

 

Current Assets (2016) = 4,338

Current Liabilities (2016) = 3,305

Working Capital (2016) = 4,338 – 3,305 = $ 1,033 million

Working Capital (2015)

Current Assets (2015) = 4,384

Current Liabilities (2015) = 3,534

Working Capital (2015) = 4,384 – 3,534 = $850 million

Net change in Working Capital = 1033 – 850 = $183 million (cash outflow)

 

Analysis of the Changes in Net Working Capital

 

Change in the working capital actually means changing the value ear over-Year that is change in the current asset – change in the current liability. With the jeans in the value, it will be more understandable that why the working capital has increased or decreased.

 

Actions that will cause a change in networking capital are as follows:

  • The accounts receivable will be reduced if the company does not allow outstanding credit. But the sales may have a declining effect.

 

  • An increase in the inventory increases the usage of the cash, therefore inventory planning plays an important role in the change of working capital.

 

  • Stretching accounts payable has an impact on changing the working capital

 

  •  If the growth rate of the company is high more cash is being used for buying inventories and increasing account receivables therefore there is heavy usage of cash.

 

Cash flow is one of the most important factors to be considered when we value a company. It indicates whether the short-term assets are increased or decreased with respect to the short-term life abilities from one year to the next year.

 

Conclusion of Net Working Capital

If the networking capital is increased we can conclude that the company’s liquidity has also increased. It indicates that the company is able to utilize its existing resources in a better way. Some companies have negative working capital and some have a positive one of the basic examples are Microsoft and Walmart. Generally, companies like Walmart maintain a large amount of inventory but have negative working capital.

Besides that, the software companies generally have positive working capital because they maintain an inventory before they can sell the product. It means that the revenue can be generated without increasing current liabilities.

 

  • Cash flow cannot increase or decrease with the only change in working capital, but if it is not sufficient the company’s efficiency greatly reduces.
  • If the current assets and current liabilities increase by the same amount there will be no change in the networking capital. Furthermore,  the change is positive, it means that the change in current liabilities has increased more than the change in current assets.
  • If the change is negative, it means that the change in current assets has increased more than the change in current liabilities.

 

Difference between working capital and net working capital

  1. Working capital refers to Current Assets  (also known as gross Working Capital at some places) or, more commonly, Current Assets minus Current Liabilities.
  2. Working capital is the amount of a company’s current assets minus the number of its current liabilities. For example, if a company’s balance sheet dated July 20 reports total current assets of $323,000 and total current liabilities of $310,000 the company’s working capital on July 20 was $13,000.
  3. Net Working Capital refers to Current Assets minus Current Liabilities, but it can also exclude financing items, so it is Cash + Marketable Securities + Trade Receivables + Inventory – Trade Payables; and items like Notes Payable, Current Portion of Long Term Debt and Taxes Payable are ignored. Some people also include Prepaid Expenses and subtract Accrued Expenses from Net Working Capital
  4. A company’s net working capital is the amount of money available it has and can spend on its day-to-day business operations, such as paying short-term bills and buying inventory. Networking capital equals a company’s total current assets minus its total current liabilities.

 

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