Net working capital definition
/What is Net Working Capital?
Net working capital is the aggregate amount of all current assets and current liabilities. It is used to measure the short-term liquidity of a business, which focuses on paying bills as they come due. The net working capital figure can also be used to obtain a general impression of the ability of company management to utilize assets in an efficient manner. Ideally, a business should have a current asset balance that exceeds its current liabilities.
How to Calculate Net Working Capital
Net working capital should be calculated on a consistent basis, so that the results generated can be tracked on a trend line. To calculate it, use the following formula:
+ Cash and cash equivalents
+ Marketable investments
+ Trade accounts receivable
+ Inventory
- Trade accounts payable
= Net working capital
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How to Interpret Net Working Capital
If the net working capital figure is substantially positive, it indicates that the 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 tracked on a trend line, since this may show a gradual improvement or decline in the net amount of working capital over an extended period. Generally, a 2:1 ratio of current assets to current liabilities is considered to be an adequate amount of net working capital.
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.
Problems with Net Working Capital
The net working capital figure can be extremely misleading, for the reasons noted below.
Impact of a Line of Credit
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. Instead, the line of credit is used whenever an obligation must be paid. A more nuanced view is to plot net working capital against the remaining available balance on the line of credit. if the line has been nearly consumed, then there is a greater potential for a liquidity problem.
Anomalies as of the Measurement Date
If only measured as of one date, the measurement may include an anomaly that does not indicate the general trend of net working capital. For example, a large one-time account payable may not yet be paid, and so appears to create a smaller net working capital figure.
Not All Assets are Liquid
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. This is a particular problem when large customers have considerable negotiating power over the business, and so can deliberately delay their payments.
How to Reduce Net Working Capital
There are multiple ways to favorably alter the amount of net working capital. One option is to require customers to pay within a shorter period of time. However, this can be difficult when customers are large and powerful. Another options is to be more active in collecting outstanding accounts receivable, though there is a risk of annoying customers when collection activities are overly aggressive. A third option is to engage in just-in-time inventory purchases to reduce the inventory investment, though this can increase delivery costs. You might also consider returning unused inventory to suppliers in exchange for a restocking fee. Or, consider extending the number of days before accounts payable are paid, though this will likely annoy suppliers. Extending the payable days is most effective when you can offer volume purchases in exchange.
Net Working Capital for Projects
Many proposed capital expenditures have some amount of net working capital associated with them. For example, the purchase of equipment to manufacture a new product line will require the incurrence of a payables liability for the raw materials required to produce goods, while receivable and inventory investments will also be required. The amount of net working capital should be considered when deciding whether to invest in a proposed project.
Reporting Net Working Capital
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. Depending on the situation, they may report net working capital as frequently as every day.
Terms Similar to Net Working Capital
Net working capital is also known as working capital.
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