Net working capital, also known as working capital is the money/assets a company needs to fend for its short term expenses. Short term expenses would include day to day requirements, cash, short term debt, raw material and a few others. Since the two terms are the same, they will be used interchangeably in the article.
In this article
What is Working Capital?
Net working capital is defined as the difference between a company’s current assets and its current liabilities on its balance sheet. Used to measure the short-term liquidity of a business, it is calculated using line items from a business’s balance sheet. Working capital is a measure of a company’s liquidity and its ability to cope up with short-term obligations, as well as fund operations of the business. The larger a company’s working capital is, the more likely it is that the company will be able to finance its short term expenses and debt obligations.
What is the Net working capital Formula?
Net working capital tells us about financial health and more specifically short term financial health.
NWC: Current Assets – Current Liabilities
Current assets and current liabilities are two items that will be there in the balance sheet of any company, listed or unlisted. Current assets are those assets that can be converted easily into cash and have the ability to do so in a year. Similarly, current liabilities are those debt obligations that need to be paid off within a year. Read on to find out more on what are the components that fall under the calculation of current assets and current liabilities.
Components of Net Working Capital
Since the calculation of working capital includes current assets and current liabilities, we will have to take into account the business transactions that fall under these two parameters.
What are Current Assets?
Current assets are assets that can be easily liquified into cash. Companies generally follow a timeline of one year for this. Hence those assets that can be converted into cash within a year will fall under the current assets category. Examples of such current assets in India are cash and cash equivalents, accounts receivables, inventory, marketable securities, prepaid expenses and any other assets that will qualify.
- Cash equivalents are financial instruments that can be immediately converted into cash. For example, a bank cheque is a cash equivalent.
- Accounts Receivables: Accounts receivables is money that the company is due to receive within a year—products sold to customers on credit, services rendered on credit etc.
- Inventory: Inventories are goods that are used by a company in its business. This is considered as a current asset.
- Marketable securities: Treasury bills, short term deposits and other money market instruments that have a maturity period of up to one year.
What are Current Liabilities?
Current liabilities are debt obligations that a company owes and expects to pay back within a year. These can be short term debt or an old long term debt that is due within a year and the company needs to pay for it.
Here’s what comprises current liabilities:
- Notes Payable: Notes payable is any amount a company owes to its creditors within a short period
- Accounts Payable: Accounts payable is the money a company has to pay to its suppliers or manufacturers when it buys goods on credit.
- Short Term loans: Short term loans are those loans where the maturity period is up to one year and are used for short term obligations.
- Accrued Expenses: These are expenses that have not yet been paid for.
- Current Portion of Long Term Debts: Any short term obligations towards long term loans like principal payments or interest payments and any other short term payable expenses.
Knowing what the components of current assets and current liabilities are should give a deeper understanding of what is working capital.
Types of Net Working Capital
The types of working capital depend on which view a company takes. There are two ways a company can do this:
Balance Sheet View
If a company takes 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 and gross working capital is just the current assets in the balance sheet.
Operating Cycle View
If a company takes an operating cycle view, then the working capital will be classified into:
Temporary Working Capital: Difference between net working capital and permanent working capital.
Permanent Working Capital: Permanent working capital accounts for the fixed assets of the company.
Why is Net Working Capital Significant?
Net working capital (NWC) or working capital is important because it indicates a company’s liquidity position. A company’s liquidity is an excellent sign of how a company is growing. And, on mapping a trend of working capital numbers over the years and in different economic conditions, it will be visible how the company’s liquidity has fared against testing conditions and how has the company grown in line with it. Negative working capital means that a company owes more than it owns and a prolonged negative net working capital condition may be bad for the company.
Another important point to consider about working capital is that it is instrumental to some extent in maintaining a company’s cash flow. If the company is too slow in retrieving pending money from customers or any other assets that are yet to be realised, then the cash flow of the company may see a dip. In other ways, a company’s cash flow can be used to boost its working capital for investment in projects.
How to Improve Net Working Capital?
Small businesses can implement changes to their operations in order to improve their net working capital. Some of them can be:
- Changing the payment terms to shorten the billing cycle and ensure that the customers pay you more frequently for the company’s goods or services
- Be prompt about following up with clients the moment an invoice is due, so that late payments can be collected quickly
- Unused inventory should be returned to the vendors in order to receive a refund for the cost
- If the vendor doesn’t charge late fees then consider extending the payment period.