Net Working Capital: Meaning, Types, Calculation, Formula, Uses, and Importance

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 Net Working Capital formulas:

• 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: Capital budgeting

Steps for setting up a net working capital schedule

Here are the steps an analyst would follow to forecast Net Working Capital (NWC) using an Excel spreadsheet:

• At the top of the working capital schedule, include sales and cost of goods sold from the income statement for all relevant periods. This information will help you calculate the factors needed to forecast the working capital accounts.
• Below the sales and cost of goods sold, list the relevant balance sheet accounts. Divide these into current assets and current liabilities. Make sure to exclude cash from current assets and any current portions of debt from current liabilities. To keep things clear and consistent, arrange these accounts in the same order as they appear in the balance sheet.
• Calculate totals for non-cash current assets and non-debt current liabilities. Then, subtract the non-debt current liabilities from the non-cash current assets to get the net working capital. If helpful, add a line to show the increase or decrease in net working capital from the previous period to the current period.
• Fill the schedule with historical data. You can do this by either referencing the corresponding data directly from the balance sheet or manually entering this data into the net working capital schedule. If there is already a balance sheet with forecasted periods, use that data as well by referencing it.
• If future periods for the current accounts are not available, create a section to detail the factors and assumptions for the main assets. Use historical data to work out these factors and assumptions for future periods. Use the prepared factors and assumptions to estimate the future values for these line items.

By following these steps, an analyst can create a forecast for net working capital effectively, helping to ensure the business remains financially healthy. This process is crucial for making sure the firm has enough cash flow to meet short-term needs and keep operations running smoothly. Good forecasting supports better decision-making and strategic planning for future growth or investments.

In short, forecasting net working capital in Excel involves referencing initial financial data from the income statement, listing the right balance sheet accounts, calculating necessary subtotals, filling in historical data, and preparing assumptions and drivers for the future. This organised approach helps analysts provide insights into a company’s financial status and its ability to manage short-term assets and liabilities efficiently.

Components of net working capital

Since working capital is calculated using current assets and current liabilities, it is essential to consider all business transactions that fall within these two categories.

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: Accounts payable include 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.

Different types of net working capital

The classification of working capital depends on the perspective a company adopts. Broadly, there are two approaches to defining it:

Balance Sheet Approach

When a company follows the balance sheet view, working capital is typically defined in two ways:

• Net working capital: This is the difference between current assets and current liabilities.
• Gross working capital: This refers solely to the total value of current assets as recorded on the balance sheet.

Operating Cycle Approach

In contrast, the operating cycle view classifies working capital into:

• Permanent working capital: Refers to the baseline level of current assets required to support the regular operations of the business, often linked to the company’s fixed or long-term asset base.
• Temporary working capital: This is the excess over permanent working capital and varies depending on seasonal or short-term business needs.

Use of net working capital in financial modelling

Net working capital (NWC) plays a crucial role in financial modelling as it helps analysts assess a company’s short-term financial health and its ability to meet short-term obligations. NWC is calculated by subtracting current liabilities from current assets. This figure indicates whether a company can cover its short-term debts with its short-term resources. In financial modelling, understanding and forecasting NWC is vital because it directly impacts cash flow projections, which are essential for valuing a business and making strategic decisions.

When creating financial models, analysts start by examining historical NWC data to identify trends and understand a company’s operational efficiency. They look at components such as accounts receivable, inventory, and accounts payable to make informed predictions about future working capital needs. These projections are integrated into the financial model to estimate future cash flows, which are critical for assessing a company's value.

Changes in NWC have a direct effect on unlevered free cash flow, which is the cash available before making debt payments. For example, an increase in accounts receivable or inventory without a corresponding increase in accounts payable can reduce cash flow, indicating that more money is tied up in operations. On the other hand, efficient management of these components can improve cash flow, making the company more financially stable and able to seize growth opportunities.

Accurate NWC forecasting is also important for planning business expansions or mergers and acquisitions. Understanding how such activities will affect current assets and liabilities helps in determining the company’s financing needs. Efficient NWC management allows companies to free up cash tied in excessive inventory or overdue receivables, which can then be used for other productive purposes like investments or debt repayment, enhancing overall value.

In summary, NWC is a vital element in financial modelling as it affects a company’s cash flow, valuation, and ability to meet short-term obligations. Proper management and forecasting of NWC can provide significant strategic advantages and improve financial decision-making. For those interested in mastering this area, resources like the Corporate Finance Institute offer valuable courses and insights into advanced financial modelling techniques.

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.

Steps to improve net working capital

Small businesses can enhance their net working capital by making adjustments to how they manage operations. Some effective strategies include:

• Revising payment terms to shorten the billing cycle, encouraging customers to make payments more frequently for the company’s products or services
• Following up immediately with clients once an invoice is due to speed up the collection of outstanding payments
• Returning unused inventory to suppliers to recover costs and avoid excess stock
• Extending payment timelines with vendors if no late fees are involved, thereby preserving cash flow for longer periods

Difference between gross working capital and net working capital

Gross Working Capital refers to the total amount of current assets a company holds, including cash, inventory, receivables, and other short-term assets. It represents the overall liquidity available for day-to-day operations.

Net Working Capital, on the other hand, is calculated by subtracting current liabilities from current assets. It provides a more precise measure of a company’s operational liquidity and financial health by focusing on the assets available to cover short-term obligations. Essentially, while gross working capital indicates total resources, net working capital reflects the actual capital available for operational needs after settling short-term liabilities.

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.