The net working capital (NWC) shows the business's ability to pay off its current liabilities and short-term debts using its current assets. The NWC indicates the health and solvency of a company. A positive NWC indicates that the company is capable of meeting all its current debts. In contrast, a negative NWC indicates that it will struggle to repay its short-term liabilities and might be tottering towards distress.
This article will provide information on net working capital, the formula used to calculate it, the net working capital Ratio, measures to be taken to improve NWC, its impact on the business, changes in the working capital, and other details!
Did you know?
A very high working capital ratio is not good either for a business as it shows that the business holds its inventory for a long time and takes a long time to convert its accounts receivables to cash. It also means that the business is holding extra cash which should be invested or used in its expansion.
What is Net Working Capital?
Net working capital (NWC) or Working capital is the difference between a business's current assets and current liabilities. NWC shows a company's or business's health in terms of its liquidity potential, the efficiency of operations, and its short-term financial status and ability. A company or business with a positive NWC possesses the potential to invest its finances and attain growth. If a company's current assets do not reach beyond but fall behind the current liabilities, the company might be moving toward distress.
Definition of Current Assets
All the assets of a company that may be used or sold during the business operations within the current financial year are known as current assets. The cash available, other cash equivalents like short-term govt. Bonds, money market funds, treasury bills, commercial paper, securities, stock, and accounts receivable come under the current assets.
Definition of Current Liabilities
The short-term financial liabilities to be paid in a year are known as the current liabilities. Short-term loans, accounts payable, other debts- trade debts, vendor notes, and accrued liabilities/ payments come under current liabilities. Payments towards small business loans and commercial real estate loans (made within the next year) are current liabilities.
Importance of Net Working Capital
Net working capital is necessary so that the business remains solvent. If a business invests all the previous year's earnings simultaneously, it will be left with insufficient working capital to pay for its short-term liabilities. It is to be understood that a perfectly profitable business can also go bankrupt if investments and debts are not managed efficiently.
For example, XYZ co. has ₹15,00,000 as retained earnings. Suppose the company decides to invest the whole amount at once. In that case, it could fall into a situation where the working capital ratio dips below 1, and the current assets are insufficient to meet the current liabilities. This affects the solvency of the business.
What Is the Formula to Calculate Net Working Capital?
There are various methods to calculate the net working capital depending on the analysis required.
- Net Working Capital (NWC) = Current Assets (CA) – Current Liabilities (CL)
- Net Working Capital (NWC) = Current Assets (minus cash) – Current Liabilities (minus debt)
- Net Working Capital (NWC) = Accounts Receivable Stock (Inventory) – Accounts Payable
Net Working Capital Example
Let's take the example of the XYZ Store. The following are its current assets and liabilities:
- Cash in hand: ₹ 15,000
- Stock: ₹ 10,000
- Accounts Receivable: ₹ 5,000
- Accounts Payable: ₹ 7,000
- Accrued Expenses: ₹ 3,000
- Other Debts: ₹ 5,000
Now, to calculate the Net Working capital, we will use the below-given NWC formula.
Net Working Capital (NWC) = Current Assets (CA) – Current Liabilities (CL)
NWC= ₹ 30,000 - ₹ 15,000
NWC= ₹ 15,000
Since the business's current assets exceed the current liabilities, the Working capital is positive. This shows that XYZ Store can pay all the Current liabilities using the current assets. This shows the short-term liquidity of the business.
Net Working Capital Ratio
The net working capital ratio shows the net amount of working capital elements. It is calculated to show whether a business has sufficient liquid funds to remain operational in the short term. It provides an idea of the business's overall health and liquidity.
The formula to calculate the working capital ratio is:
Working Capital Ratio = Current Assets / Current Liabilities
If the ratio is higher, the business has greater flexibility to expand, whereas a lower ratio shows distress. The net working ratio should at least be 1:1.
Changes in Net Working Capital
Changes in net working capital show the changes in cash flow during business operations. This helps in estimating whether the short-term business assets are increasing or decreasing as compared to the current liabilities. The knowledge of the upward/ downward change in working capital is helpful in assessing the trends in liquidity during a set period of time.
The formula to measure the changes in net working capital is:
Net working capital = (Current Net Working Capital) – (Previous Net Working Capital)
Improving the Net Working Capital
To improve the working capital, businesses or companies can follow the below-given points:
- Keeping the net working capital ratio in check
- Improving Stock management
- Automate processes for your business financing
- Managing expenses to improve cash flow
- Sell Some Long-term Assets for Cash
- Increase the Stock Turnover
- Refinance into Long-term Debt
- Incentivise receivables
- Establishing penalty for late payments
- Managing the debt obligations
- Resolving disputes with customers and vendors
- Analysing the credit risk
- Tracking business performance
- Using tax incentives
- Working with vendors offering better deals and discounts
- Consulting specialists
How does Working Capital Impact Your Business?
In a business managing the working capital efficiently or insufficiently impacts the business positively or negatively. A positive working capital ratio shows that the business is solvent and can pay its short-term debts or liabilities. A vice-versa or negative working capital shows that the company will face financial problems in settling its current liabilities. A high net working capital ratio is not good for the business either. It shows that the business holds its inventory for a long time, i.e., taking time to sell them, and also that the business is holding extra cash which should be invested or used in its expansion. It isn't easy to decide how much working capital is enough for a business to flourish. The need for the amount of working capital is in accordance with the type and growth opportunities of the business.
We hope this article has been helpful in providing all relevant details related to net working capital. NWC measures a business's capacity to meet its current financial liabilities. When the working capital is positive, the business has sufficient current assets to pay off its short-term debts. There is also scope for expansion and investment. The companies should keep a constant check on their working capital and implement ways to improve it.
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