Net Working Capital
Net working capital is a liquidity calculation that measures a companyís ability to pay off its current liabilities with current assets. This measurement is important to management, vendors, and general creditors because it shows the firmís short-term liquidity as well as managementís ability to use its assets efficiently.
Much like the working capital ratio, the net working capital formula focuses on current liabilities like trade debts, accounts payable, and vendor notes that must be repaid in the current year. It only makes sense the vendors and creditors would like to see how much current assets, assets that are expected to be converted into cash in the current year, are available to pay for the liabilities that will become due in the coming 12 months.
If a company canít meet its current obligations with current assets, it will be forced to use itís long-term assets, or income producing assets, to pay off its current obligations. This can lead decreased operations, sales, and may even be an indicator of more severe organizational and financial problems.
The net working capital formula is calculated by subtracting the current liabilities from the current assets. Here is what the basic equation looks like.
Typical current assets that are included in the net working capital calculation are cash, accounts receivable, inventory, and short-term investments. The current liabilities section typically includes accounts payable, accrued expenses and taxes, customer deposits, and other trade debt.
Some people also choice to include the current portion of long-term debt in the liabilities section. This makes sense because although it stems from a long-term obligation, the current portion will have to be repaid in the current year. Thus, itís appropriate to include it in with the other obligations that must be met in the next 12 months.
Letís look at Paulaís Retail store as an example. Paula owns and operates a womenís clothing and apparel store that has the following current assets and liabilities:
- Cash: $10,000
- Accounts Receivable: $5,000
- Inventory: $15,000
- Accounts Payable: $7,500
- Accrued Expenses: $2,500
- Other Trade Debt: $5,000
Paula would can use a net working capital calculator to compute the measurement like this:
Since Paulaís current assets exceed her current liabilities her WC is positive. This means that Paula can pay all of her current liabilities using only current assets. In other words, her store is very liquid and financially sound in the short-term. She can use this extra liquidity to grow the business or branch out into additional apparel niches.
If Paulaís liabilities exceeded her assets, her WC would be negative indicating that her short-term liquidity isnít as high as it could be.
Obviously, a positive net WC is better than a negative one. A positive calculation shows creditors and investors that the company is able to generate enough from operations to pay for its current obligations with current assets. A large positive measurement could also mean that the business has available capital to expand rapidly without taking on new, additional debt or investors. It can fund its own expansion through its current growing operations.
A negative net working capital, on the other hand, shows creditors and investors that the operations of the business arenít producing enough to support the businessí current debts. If this negative number continues over time, the business might be required to sell some of its long-term, income producing assets to pay for current obligations like AP and payroll. Expanding without taking on new debt or investors would be out of the question and if the negative trend continues, net WC could lead to a company declaring bankruptcy.
Keep in mind that a negative number is worse than a positive one, but it doesnít necessarily mean that the company is going to go under. Itís just a sign that the short-term liquidity of the business isnít that good. There are many factors in what creates a healthy, sustainable business. For example, a positive WC might not really mean much if the company canít convert its inventory or receivables to cash in a short period of time. Technically, it might have more current assets than current liabilities, but it canít pay its creditors off in inventory, so it doesnít matter. Conversely, a negative WC might not mean the company is in poor shape if it has access to large amounts of financing to meet short-term obligations such as a line of credit.
What is a more telling indicator of a companyís short-term liquidity is an increasing or decreasing trend in their net WC. A company with a negative net WC that has continual improvement year over year could be viewed as a more stable business than one with a positive net WC and a downward trend year over year.
Change in Net Working Capital
You might ask, ďhow does a company change its net working capital over time?Ē There are three main ways the liquidity of the company can be improved year over year. First, the company can decrease its accounts receivable collection time. Second, it can reduce the amount of carrying inventory by sending back unmarketable goods to suppliers. Third, the company can negotiate with vendors and suppliers for longer accounts payable payment terms. Each one of these steps will help improve the short-term liquidity of the company and positively impact the analysis of net working capital.
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