Net Working Capital: Formula and Components

How to Calculate Net Working Capital?

Net working capital (NWC) is a measure of a company’s liquidity and its ability to meet its short-term obligations. It is calculated by subtracting the current liabilities from the current assets on the balance sheet. There are different ways to calculate NWC, depending on what items are included or excluded from the current assets and liabilities. Here are some common formulas for NWC:

• NWC = current assets - current liabilities: This is the broadest formula that includes all current assets and liabilities, such as cash, accounts receivable, inventory, accounts payable, accrued expenses, etc.
• NWC = current assets (less cash) - current liabilities (less debt): This is a narrower formula that excludes cash and debt from the current assets and liabilities, as they are not directly related to the operating activities of the business.
• NWC = accounts receivable + inventory - accounts payable: This is the narrowest formula that only includes three accounts that are most relevant for the working capital cycle of the business.

A positive NWC indicates that the company has enough current assets to pay off its current liabilities, while a negative NWC suggests that the company may face liquidity problems or need external financing. NWC can also reflect the efficiency and profitability of the business, as it shows how well the company manages its cash flow and inventory turnover.

Net working capital = current assets (less cash) – current liabilities (less debt)

Here, current assets (CA) = The sum of all short-term assets that are easily convertible into cash like accounts receivable, debts owed to the company, etc. It also includes available cash.

Current liabilities (CL) = The sum of short-term liabilities that need to be paid off within the company’s operating cycle or a year.

A difference between the two thus presents the company’s liquidity, stating whether it holds sufficient assets to meet short-term liabilities.

For example, a company has the following CA and CL in its balance sheet.

• Inventories – Rs. 40,000
• Accounts receivables – Rs. 50,000
• Cash – Rs. 10,000
• Debtors – Rs. 5,000
• Creditors – Rs. 10,000
• Short-term loans – Rs. 30,000
• Income tax – Rs. 5,000

In this case, NWC will be calculated as follows:

NWC = CA – CL

= (inventories + accounts receivables + debtors – cash) – (short-term loans + income tax – creditors)

= (40,000 + 50,000 + 5,000 – 10,000) – (30,000 + 5,000 – 10,000)

= 85,000 – 25,000

= Rs. 60,000

The company thus has a net working capital of Rs. 60,000, an amount that it can use for its short-term obligations.

In case of working capital deficits, you can avail additional funds to meet your liquidity requirement. Bajaj Finserv eases this concern with its high-value working capital loan, which is available against minimum eligibility.

Additional Read: Importance of capital budgeting

Components of net working capital

Currently owned assets:

Current assets are monetary gains that a business has on hand, or expects to get in the next year:

• Cash and its equivalents: All the money that the business has on hand. This includes foreign cash and certain types of investments, like money market accounts.
• Inventory: This includes everything from raw materials to unsold finished products.
• Accounts receivable: This is a list of all cash claims for goods sold on credit.
• Notes receivable: All claims to payment for other deals, made in writing.

Current liabilities:

Current liabilities are all the debts that a company owes or is likely to owe in the next 12 months. Working capital helps figure out if a company can pay off all its bills with short-term assets it already has.

• Accounts payable: All unpaid bills to vendors for supplies, raw materials, utilities, property taxes, rent, or any other third-party running costs.
• Payroll: All the staff's unpaid pay and salaries. Depending on when the company pays its employees (if they only get one paycheque a month), this may only add up to one month's worth of wages.
• Long-term debts: All current payments on long-term debt.
• Tax owed: These could be tax payments that are not due for a few months. But most of the time, these accruals are short term (due within the next 12 months).
• Dividend payable: All payments to owners that the board approves. A company can decide not to pay dividends in the future, but it must keep paying dividends that are already due.
• Unearned revenue: Any money that comes in before the completion of work. If the company does not finish the job, the client may have to give back the money.

Problems arising due to insufficient net working capital

When a business faces a shortage of net working capital, it can lead to several problems that can impact its financial health. Here are some of them:

• Cash flow shortages, making it difficult for the business to pay for fixed and variable expenses
• An inability to invest in growth opportunities, which can affect competitiveness in the marketplace
• Difficulty in meeting customer demands and expectations, which can lead to lost sales and diminished reputation
• Limited ability to respond to market changes and trends, making it harder to stay ahead of the competition

Why is net working capital important?

Net working capital (NWC) is a critical financial metric that measures a company's liquidity and ability to meet its short-term obligations. The concept refers to the difference between a company's current assets and current liabilities, and reveals the amount of cash available to cover daily operational expenses and short-term debt obligations. Here are some reasons why net working capital is important for businesses:

1. Ensures business continuity: Having sufficient NWC ensures that the business has enough cash to meet its short-term expenses and continue operations smoothly.
2. Facilitates borrowing: Lenders often look at a company's NWC to determine its creditworthiness and ability to repay loans.
3. Provides financial flexibility: A company with a positive NWC has the ability to invest in new projects, take advantage of new market opportunities, and weather unforeseen challenges.
4. Indicates efficiency: Companies with a positive NWC are better able to manage inventory, collect receivables, and pay suppliers on time, reflecting sound financial management practices.

Overall, maintaining a healthy level of NWC is essential for a business to sustain its operations, pursue growth opportunities, and achieve long-term success.

An unsecured business loan can be a viable solution for businesses looking to address working capital shortfalls. It can provide the necessary funds to ensure the smooth running of business operations while the business grows.