Net Working Capital: Meaning, Formula and Essential Insights for Investors

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Introduction

Every company has assets and liabilities, some assets may get realized earlier than others and the company needs to pay some liabilities earlier than others. A company at any time needs liquidity to operate its business. 

Net working capital shows us the excess amount of current assets over current liabilities.

Let us understand the fundamentals of Net working capital meaning.

What are current assets?

Current assets describe all of the company’s assets that appear to be sold, used, used, or eliminated through normal business activities within a single year.

Current assets are shown on the balance sheet under the head of the current asset after the head of the fixed asset. E.g., cash and cash equivalents, Inventories, credit receivables, etc.…

What are current liabilities?

Current liabilities are short-term financial obligations that must be settled within one year or during a company’s operating cycle. Current debts are different from long-term debt, which refers to debts or obligations to be repaid over one year.

Current liabilities are shown on the balance sheet under the head of the current liabilities after the head of long-term borrowings. E.g., Bank overdraft, Outstanding Expenses, Accounts Payables, etc.…

What is Net working capital?

Net working capital calculation is executed as follows:

Net Working Capital = Current Assets (Gross working capital) – Current Liabilities.

If the result is positive then, the company’s current assets exceed the current liabilities which means the company’s financial stability is good and it can repay the liabilities within the stipulated period.

If the result is negative that means business owners need to improve the financial strategy of the business so they can repay liabilities in the upcoming future.

Components of Net working capital.

The current assets and liabilities used to calculate working capital typically include the following items:

Current assets include cash and other liquid assets that can be converted to cash within one year of the balance date, including:

1)    Cash, which includes money in bank accounts and savings checks from customers.

2)    Bonds for sale, such as Marketable Bonds.

3)    A short-term investment that the company intends to sell within a year.

4)    Accounts Receivables.

5)    Receivable notes – such as temporary loans to customers or providers – mature within one year.

6)    Other receivables, such as income tax returns, employee benefits, and insurance claims.

7)    An inventory comprising materials, Work in Progress, and Finished Goods.

8)    Prepayments of expenses.

9)    Advance payments for future purchases.

10) Other Current Assets.

–       Current liabilities are all liabilities due within a year of the balance sheet date, including:

1) Accounts payable.

2) Notes payable due within one year.

3) Wages payable.

4) Taxes payable.

5) Interest payable on loans.

6) Any loan principal that must be paid within a year.

7) Other accrued expenses payable.

8) Other Current Liabilities.

 Net Working Capital Formula

The formula of Net working capital is as follows:

Net working capital = Total current assets – Total Current Liabilities.

Net Working Capital Example

Suppose a company has a cash balance of Rs. 8000, Bank balance of Rs. 12000, Debtors of Rs. 10000, and inventories of Rs. 8000, Trade payables of Rs. 5500, Bank overdraft of Rs. 5000 and other current liabilities of Rs. 6000. Then,

Net working capital = Total current assets – Total Current Liabilities.

Cash + bank + debtors + inventories – Trade payables – Bank overdraft –         other current liabilities.

Gross working capital = Rs. 8000 + Rs. 12000 + Rs. 10000 + Rs. 8000 – Rs. 5500 – Rs. 5000 – Rs. 6000 = Rs. 21500.

Positive Net Working Capital vs Negative Net Working Capital.

A company has positive Net working capital when it has enough cash, accounts receivable, and other liquid assets to meet its short-term obligations, such as payable accounts and short-term debt.

In contrast, a company has a negative Net working capital if it does not have sufficient current assets to cover its short-term financial obligations. A company with an unsecured income may have difficulty paying suppliers and creditors as well as difficulty finding funds to drive business growth. If the situation persists, it may eventually be forced to close.

Why is Net Working Capital Important?

The amount of net working capital is important because it gives an idea of ​​the liquidity of the business and whether the business has enough money to cover its short-term obligations. 

If the net working capital is zero or more, an entity can cover its current obligations. Generally, the larger the net working capital, the better prepared the business will be to cover its short-term obligations. 

Businesses should always be able to maintain enough liquidity to pay off all their debts for a year.

Net working capital is very useful when used to compare how the value changes over time, so you can establish a trend in your business spending and liquidity. It helps to see if it is improving or declining. 

If your business net working capital is mostly positive, that is a good sign that you can meet your current obligations. If there is too much gauge, that suggests that your business is unable to make its future payments and may be in danger of collapsing.

The amount of net working capital can also indicate how fast a company can grow. If an entity has a significant set of capital, it can measure its performance quickly, by investing in better-utilised assets, for example.

How to Improve Net Working Capital?

Businesses can make some changes in their operations if they want to improve their overall Net working capital. Some of those changes include:

–       Change your payment terms to reduce your payment cycle and ensure that your customers pay you regularly for your goods or services

–       Be diligent in tracking clients as soon as the invoice arrives, so you can collect late payments as soon as possible.

–       Return a list of unused goods to your dealers for a refund of expenses.

–       Extend the payment period to your merchants, if they will allow it without charging late fees.

Net Working Capital Ratio.

The net working capital ratio is nothing other than representing the percentage of the company’s current assets and liabilities.

Although the NWC is calculated by deducting current assets and current liabilities, the measure can be achieved by dividing assets by liabilities. This measure, similar to the NWC, helps determine if your company has sufficient assets to pay off debts.

Therefore, the mathematical equation to calculate the Net working Capital is as follows:

Net Working Ratio = Current Assets / Current Liabilities.

Ideally, the fair ratio should be between 1.2 – 2 times the carrying amount of current assets to current liabilities. If you see a high number, it may mean that your company is not using its current assets at their maximum.

Effect of certain transactions on Working capital

Some transactions may affect the working Capital of the company and some might not. 

The transactions that affect the working Capital may cause an increase or decrease in the working Capital, while the transactions not affecting the working capital result in no change in working capital.

There are some accounting activities that cause a change in working capital

Listed below are headings that help you understand the effect of such activities on the working capital.

Increase in working capital

The activities that result in an increase in the working capital are as follows:

Issue of Debentures

Issuing debentures will cause an increase in the working Capital as cash inflow will occur and a long-term financial liability will be created. 

The Debentures issued are not the current liabilities of the company while cash is a current liability. 

Thus, issuing the debentures increases both gross working capital and net working Capital of the company.

Sale of non-current assets

Selling a non-current asset will cause an increase in the working Capital of the company as the cash inflow will occur, and a non-current asset will be disposed of. 

Thus, selling a non-current asset will increase both gross working capital and net working Capital.

Decrease in Working capital

The activities that result in the decrease of the working capital are as follows:

Redemption of Debentures

The redemption of debentures means repaying the debentures. 

It decreases the working Capital as a cash outflow will occur and Debentures get paid off. This transaction decreases the current assets and non-current liability.

Thus, redeeming the debentures decreases the gross working Capital and the net working capital.

Purchase of non-current assets

Purchasing a non-current asset will cause a decrease in the working Capital of the company as the cash outflow will occur and a non-current asset is added. 

Thus, purchasing a non-current asset will result in a decrease in both gross working capital and net working Capital.

Transactions that do not affect working capital

• A shift from one current asset to another current asset by an equal amount or from one current liability to another current liability by an equal amount these transactions do not affect the working Capital of the company.  

For example, withdrawing cash from a bank account will affect the cash in hand and the bank balance but it will not affect the working Capital of the company. 

In the same way, depositing cash to a bank account will affect the cash in hand and the bank balance but it will not affect the working Capital of the company.

• A transaction involving only the non-current asset and liability: A transaction that does not have any working capital element will not affect the working Capital of the company. 

For example, When you are purchasing a machine in exchange for shares of the company, there is an increase in the non-current asset and equity of the company.

Thus, it does not affect the working Capital of the company.

How to manage working capital?

Before knowing how to manage the working capital, we need to know why is it important for an entity to manage its working capital. Net working capital is the difference between total current assets and total current liabilities.

By managing the working capital, entities try to manage the current assets and current liabilities and analyse the interrelationship that exists between them. Thus, we can say that by analysing the working capital, entities analyse the relationship between their current assets and the current liabilities.

The main aim to manage the working capital is to deploy such amounts to current liabilities and current assets to maximise the short-term liquidity. Now let us dig into the management of working capital:   

The management of working capital involves the management of components of working capital, i.e., inventories, accounts receivables, cash, bank, etc., there are two core steps to manage the working capital:  

1)    Forecasting the amount of working capital.

2)    Determining the source of working capital.

What is Gross working Capital?

Gross working capital consists of all the current assets of the company. Gross Working Capital refers to the concept of quantitative nature.  

It means the total sum of such assets which can be converted easily into liquid form I.e., cash within one year. It is an integral part of small companies as these companies depend most on their current assets, but it never shows the true liquidity of the company.  

However, it does not add any significance to large and mid-size firms. Overall, Gross Working Capital =Current Assets.

How is Gross working capital different from Net working capital?

The gross working capital differs from net working capital in various aspects. 

In order to cover the difference in an easy manner, here is an all-encompassing chart explaining Gross working capital v/s net working capital.

Serial No.	Parameter	Gross Working Capital.	Net working Capital.
1.	Meaning	Gross working capital is the summation of the current assets of the firm.	Net working capital is the difference between total current assets and total current liabilities of the firm.
2.	Concept.	Gross working capital is a quantitative concept.	Net working capital is a qualitative concept.
3.	Indicates what?	Gross working capital indicates the funds invested in the current assets of the firm.	Net working capital indicated the firm’s capacity to pay its current liabilities and operating expenses with no problem.
4.	When does it change?	The value of Gross working capital changes with a change in the value of the current asset.	The value of net working capital changes only when a transaction has the first effect on current assets or liabilities and the second effect on non-current assets or non-current liabilities.
5.	Components.	Components of Gross working capital are; Accounts Receivables, cash, cash equivalent, current investments, marketable securities, inventories, and other current assets.	Components of Net working capital are; Total current assets and the total current liabilities of the firm.
6.	Formula.	Gross working capital = Cash and cash equivalent + Accounts receivables + marketable securities + inventories + short term investments + other current assets.	New working capital = Total current assets – total current liabilities.
7.	Suitable to whom?	Gross working capital is normally suitable for companies.	New working capital is normally suitable for partnership firms and sole traders.
8.	Use.	The Gross working capital concept is used to know the financial standing of the firm.	The Net working capital is used to know the liquidity of the firm.
9.	Popularity in which field?	Gross working capital is popular in financial management.	Net working capital is popular in accounting systems.

Conclusion:

Net working capital takes into consideration all the current assets and the current liabilities of the firm. Net Working Capital refers to the concept of qualitative nature.  

It means the total sum of such assets which can be converted easily into liquid form I.e., cash within one year less the total sum of such liabilities which are to be paid in 12 months i.e., trade payables, interest on loans, bank overdrafts. 

It shows the excess amount of cash a firm will have if all its current liabilities are paid off by using its current assets.