Understanding Net Working Capital – Essential Formulas & Ratios

Net working capital is one of the foremost concepts used to assess business success and gauge a company’s operational efficiency. Whether it is the business’s financial health, cash flow management, or meeting short-term liabilities, understanding what net working capital is, how it is calculated, and its significance can help business owners fine-tune their strategies.

What is Net Working Capital?

Net working capital or NWC measures a company’s short-term liquidity and its ability to meet short-term business expenses like day-to-day operational costs. It is defined as the difference between the company’s short-term assets and short-term debts and liabilities. NWC offers insights into the company’s short-term financial health, signalling if it has enough funds to meet its short-term liabilities.

Components of Net Working Capital

Net working capital calculations take the following components into account:

1. Current Assets

Current assets refer to the business’s tangible and intangible assets which can be liquified into cash within the next year or business cycle. This includes:

• Cash and its equivalents:This includes all the liquid funds the company has on hand. Cash equivalents include financial instruments which can be easily converted into cash, like bank cheques.
• Marketable securities:This include highly liquid market-linked investments in stocks and bonds, ETFs, and mutual funds.
• Inventory:Inventory includes the stockpile of the company’s unsold finished products and raw materials.
• Accounts receivable:This is the cash flow the company expects to receive within a year for products/services sold on credit to customers.

2. Current Liabilities

Current liabilities sum up the company’s debt obligations that it expects to pay off within the next year or business cycle. This includes:

• Accounts payable: This refers to the money the company owes to its suppliers. Payments for rent, utilities, raw materials, supplies, property taxes, or any other third-party vendor are included in this category.
• Payroll: This includes salaries payable to the company’s staff or workers.
• Short-term loans: Short-term debts with a payment window of 12 months are included in this category.
• Current payments of long-term debts: Short-term payment obligations for long-term loans like principal or interest payments are included in this category.
• Payable dividends: Dividends due to stockholders within the next 12 months.
• Accrued tax: Taxes payable by the company within the next year.

Also Read: Apply for Working Capital Loan

How to Calculate Net Working Capital?

There are different ways of computing net working capital for a company, depending on the inclusions and exclusions in the current assets and current liabilities lists. Here’s a list of common formulas used to compute NWC:

• Formula 1: NWC = Current Assets (CA) – Current Liabilities (CL)
• Formula 2: NWC = Current Assets (less cash) – Current Liabilities (less debt)
• Formula 3: NWC = Accounts Receivable + Inventory – Accounts Payable

To calculate the NWC for a company using the broadest formula, let’s assume that company A has listed Rs. 1,90,000 in current assets and Rs. 50,000 in current liabilities on its balance sheet. As NWC calculations using the first formula will be:

NWC = CA – CL

NWC = Rs. 1,90,000 – Rs. 1,15,000

NWC   = Rs. 75,000

A positive NWC of Rs. 75,000 suggests that company A has enough funds to meet its short-term obligations. Alternatively, if a negative NWC figure signals working capital deficits, that may impact short-term liquidity and cash flows.

Also Read: Working Capital Requirement Calculation- Formula & Ratio

Calculating Net Working Capital Ratio

NWC is usually expressed as a ratio using the following net working capital ratio formula:

Using the same example, where the total value of current assets was Rs. 1,90,000, and the total value of current liabilities was Rs. 1,15,000, we can also compute the NWC ratio.

NWC Ratio = 1,90,000/1,15,000

NWC Ratio = 1.65

While the optimum net working capital ratio can vary from industry to industry, figures between 1.5 and 2.0 are generally considered ideal to meet outstanding short-term liabilities without jeopardising the current asset balance. Ratios below one are considered negative since they can indicate a need for external financing to meet current outstanding liabilities.

Why is Net Working Capital a Significant Metric for Businesses?

Knowing what net working capital is and how to calculate it helps you gauge its importance as a key business metric. Here are a few reasons why net working capital is an essential metric for business success:

• Gauge short-term liquidity: Net working capital calculations help you map a business’s liquidity position and understand if the company has enough funds to meet its short-term obligations without opting for external financing.
• Assess operational efficiency: Net working capital is directly linked to short-term cash flows. Positive net working capital indicates no cash flow shortages when meeting day-to-day operational expenses like paying suppliers, meeting payroll, and covering rent expenses.

• Seize investment and growth opportunities: Positive net working capital helps the company exploit potential growth opportunities, like investing in a new project or expanding operations. This also allows companies to capitalise on emerging market trends successfully and preserve a competitive edge.
• Sway investor confidence: Investors assess a company’s net working capital as part of their due diligence. A positive net working capital figure conveys the company’s ability to manage cash flows efficiently, boosting investor confidence.
• Convey creditworthiness: Creditors assess a company’s net working capital figures before sanctioning a business loan. Positive net working capital indicates the creditworthiness of the business and its ability to efficiently manage funds, allowing companies to secure financing on favourable terms.

In conclusion, understanding net working capital can be critical for businesses to manage their working capital effectively. Doing so can help companies maintain enough funds for day-to-day short-term expense management as well as invest in long-term growth opportunities. That said, NWC figures are better tracked on a trend line since this gives you insights about NWC rising or falling over the long run.

Frequently Asked Questions:

How do you calculate net working capital?

Net working capital is calculated by subtracting a company’s current liabilities from its current assets. For instance, if the current assets of a business stand at Rs. 1,50,000 and current liabilities at Rs. 50,000. The NWC for this business will be Rs. 1,00,000.

What is meant by net working capital ratio?

The net working capital ratio is obtained by dividing the company’s current assets by its current liabilities. This ratio measures whether the company can pay off its short-term debts and liabilities with its current assets.

How can NWC be interpreted?

NWC is crucial for investors and creditors since it shows if the company can pay off its short-term debt. A company’s NWC can be interpreted as follows:
A positive NWC suggests the company has enough short-term liquidity to cover its current liabilities. This is a positive sign since the company has enough funds to pursue growth avenues.
A negative NWC indicates a short-term liquidity crunch and cash flow shortage. Investors can interpret this as operational inefficiency.