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What is working capital?
Working capital, also known as net working capital (NWC), is the difference between a business’s short-term assets, such as cash flow, customer accounts receivable / unpaid invoices, and inventory of raw materials and finished products, and its current liabilities, such as accounts payable and debts.
The NWC is a measure of a company’s liquidity, operational efficiency, and short-term financial health. If a business has a substantial positive NWC then it should have the potential to invest and grow. If a company’s current assets do not exceed its current liabilities, it may have difficulty growing or repaying its creditors. He could even go bankrupt.
Key points to remember
- Working capital, also known as net working capital (NWC), is the difference between a company’s current assets and current liabilities.
- The NWC is a measure of a company’s short-term liquidity and financial health.
- A business has a negative NWC if its asset / liability ratio is less than one.
- A positive NWC indicates that a company can fund its current operations and invest in future business and growth.
- A high NWC is not always a good thing. This may indicate that the business has too much inventory or is not investing its excess cash.
Understanding working capital
NWC estimates are derived from the range of assets and liabilities on a corporate balance sheet. Listed current assets include cash, accounts receivable, inventory, and other assets that are expected to be liquidated or turned into cash in less than a year. Current liabilities include accounts payable, salaries, taxes payable and the current portion of long-term debt due within one year.
To calculate NWC, compare the first with the last, in particular, subtract one from the other. The standard formula for NWC is current assets minus current liabilities. A business has a negative NWC if the equation produces a negative number or if its working capital ratio, which is current assets divided by current liabilities, is less than one.
In the world of corporate finance, “current” refers to a period of one year or less. Current assets are available within 12 months; current liabilities are due within 12 months.
A positive NWC indicates that a company can fund its current operations and invest in future business and growth.
An NWC that meets or exceeds the industry average for a company of comparable size is generally considered acceptable. A low NWC may indicate a risk of distress or fault.
Theresa Chiechi © Investopedia, 2019
Special considerations
Most major new projects, such as expanding production or into new markets, require investment in NWC. This reduces cash flow. However, cash flow will also decrease if money is collected too slowly or sales volumes decrease resulting in lower accounts receivable. Companies that use NWC inefficiently can increase their cash flow by reducing their suppliers and customers.
On the other hand, a high NWC is not always a good thing. This may indicate that the business has too much inventory or is not investing its excess cash.
Faq
How do you calculate net working capital (NWC)?
Net Working Capital (NWC) is calculated by taking the current assets of a business and deducting the current liabilities. For example, if a business has current assets of $ 100,000 and current liabilities of $ 80,000, then its NWC would be $ 20,000. Common examples of current assets include cash, accounts receivable, and inventory. Examples of current liabilities include accounts payable, short-term debt payments, or the current portion of deferred revenue.
What is an example of NWC?
Take the case of XYZ Corp. When XYZ started up, its NWC was only $ 10,000, with current assets averaging $ 50,000 and current liabilities averaging $ 40,000. To improve its NWC, XYZ decides to keep more cash in reserve and deliberately delay payments to vendors in order to reduce current liabilities. After making these changes, XYZ has average current assets of $ 70,000 and average current liabilities of $ 30,000. As a result, his NWC is now $ 40,000.
Why is the NWC important?
NWC is important because it is necessary that companies remain solvent. In theory, a business could go bankrupt even if it is profitable. After all, a business can’t rely on paper profits to pay its bills – those bills have to be paid in cash easily on hand. Suppose a business has accumulated $ 1 million in cash from retained earnings from previous years. If the company were to invest all $ 1 million at once, it could end up with insufficient short-term assets to pay off its short-term debts.
