Net working capital is calculated as the current assets of a business, minus its current liabilities. Net working capital gives a general indication of the short-term financial condition of a business.
Thus, if the figure is substantially positive, it indicates that the amount of short-term funds available from current assets are more than adequate to pay for current liabilities as they come due for payment. If the figure is substantially negative, then the business may not have sufficient funds available to pay for its current liabilities, and may be in danger of bankruptcy. The net working capital figure is more informative when you track it on a trend line, since this may show a gradual improvement or decline in the net amount of working capital over time.
Net working capital can also be used to estimate the ability of a company to grow quickly. If it has substantial cash reserves, it may have enough cash to rapidly scale up the business. Conversely, a tight working capital situation makes it quite unlikely that a business has the financial means to accelerate its rate of growth. A more specific indicator of the ability to grow is when accounts receivable payment terms are shorter than the accounts payable terms, which means that a company can collect cash from its customers before it needs to pay its suppliers.
The net working capital figure can be extremely misleading for the following reasons:
- A business may have a large line of credit available that can easily pay for any short-term funding shortfalls indicated by the net working capital measurement, so there is no real risk of bankruptcy.
- If only measured as of one date, it may include an anomaly that does not indicate the general trend of net working capital. For example, a large account payable may not yet be paid, and so appears to create a smaller net working capital figure.
- Current assets are not necessarily very liquid, and so may not be available for use in paying down short-term liabilities. In particular, inventory may only be convertible to cash at a steep discount, if at all. Further, accounts receivable may not be collectible in the short term, especially if credit terms are excessively long.
The amount of net working capital can be altered favorably by engaging in any of the following activities:
- Requiring customers to pay within a shorter period of time.
- Being more active in collecting outstanding accounts receivable.
- Engaging in just-in-time inventory purchases to reduce the inventory investment.
- Returning unused inventory to suppliers in exchange for a restocking fee.
- Extending the number of days before accounts payable are paid.
Tracking the level of net working capital is a central concern of the treasury staff, which is responsible for predicting cash levels and any debt requirements needed to offset projected cash shortfalls.
Net working capital is also known as working capital.