2021-01-18 21:21:01ExpensesEnglishyou will learn managing assets that act as source. Further, you will also learn what is Net Working Capital & how to calculate Net Working...https://quickbooks.intuit.com/global/resources/row_qrc/uploads/2020/12/chromebook.pnghttps://quickbooks.intuit.com/global/resources/expenses/net-working-capital/Net Working Capital: Meaning, Formula, and Example

Net Working Capital: Meaning, Formula, and Example

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In this article, you will learn:

In this article, you will learn about managing current assets that act as a source of short-term finance for your business. Further, you will also learn what is Net Working Capital and how to calculate Net Working Capital.

Managing current assets is similar to managing the fixed assets of your business. This is because you analyze the impact of current assets and fixed assets on the risk and return of your business. There are three important ways in which your current asset management differs from fixed assets management.

First, time is an important factor that you need to consider while managing your fixed assets. That is, you need to use discounting and compounding techniques in capital budgeting. However, such techniques do not play a significant role in managing your current assets.

Second, your business’s liquidity position improves and the business risk reduces if you hold large amounts of current assets. However, such a scenario reduces the overall profitability of your business. Therefore, a risk-return tradeoff is involved in managing the current assets of your business.

Third, the expected sales of your business determine the level of fixed assets and the current assets of your business. However, only the current assets change with the change in the level of sales revenue during the short-run. This means you have a great amount of flexibility in managing the current assets of your business.

 

What Is Net Working Capital?

Net Working Capital refers to the difference between the current assets and the current liabilities of your business. It, therefore, presents that part of current assets that are financed using permanent capital like equity capital, bank loans, etc.

Your business needs cash to run its core operations. For instance, you need cash to purchase raw materials, pay wages, rent, and incur other expenses. In other words, your business needs working capital in the form of cash, debtors, raw materials inventory, bills receivable, etc. This is because it helps in the smooth and continuous flow of production.

Further, your Net Working Capital can either be positive or negative. Your business would have a positive Net Working Capital when its current assets would exceed its current liabilities. However, it would have a negative Net Working Capital if its current liabilities would exceed its current assets.

Accordingly, to understand the Net Working Capital, you first need to understand what are current assets and current liabilities.

Current Assets

Current assets are the assets that can be converted into cash within a short period of time, typically one year. You use these assets for the current operations of your business. That is your business’s short-term operations. Such assets include cash, short-term securities, accounts receivable, and stock.

Thus, two characteristics define the current assets of your business. These include short lifespan and swift transformation into other forms of assets.

For instance, your business’s:

  • cash balance may be kept idle for a week or two
  • debtors or accounts receivable may pay after 30-60 days and
  • inventories may be held for 30-100 days

So, you need to optimize investment in your current assets. Besides this, you should also understand how these current assets can be financed. Accordingly, you should not invest in current assets excessively as it impacts your firm’s profitability. This is because cash remaining idle would earn nothing for your business. Likewise, inadequate investment in current assets could threaten the solvency of your business. This is because you would not be able to meet your current obligations.

Current Liabilities

Current liabilities refer to the outsiders’ claims that you must pay within an accounting year. These are your short-term liabilities towards your creditors from whom you have purchased raw materials on credit.

Examples of your current liabilities include accounts payable, bills payable, and outstanding expenses.

Thus, you must always ensure that your current assets are in excess of its current liabilities to manage the liquidity position of your firm. This is because current assets help in creating a buffer for meeting your obligations within your ordinary operating cycle. Thus, your short-term creditors always prefer that you maintain current assets higher than your current liabilities. Besides this, they also consider the quality of your current assets.

This is important because a weak liquidity position is a threat to your business’s solvency. Therefore, make sure you employ a judicious mix of short-term and long-term funds to fund your current assets.

Net Working Capital Formula

As mentioned above, the Net Working Capital is the difference between your business’s short-term assets and short-term liabilities. Accordingly, the Net Working Capital formula is as follows.

Net Working Capital Formula = Current Assets – Current Liabilities

Where Current Assets = Debtors + Bills Receivables + Prepaid Expenses + Cash in Hand and at Bank + Short-term Marketable Securities + Inventories + Accrued Income

Current Liabilities = Creditors + Bills Payable + Outstanding Expenses + Bank Overdraft + Short-Term Liabilities + Provisions for Taxation

Thus, Net Working Capital aims to provide funds to finance your current assets by current liabilities. You need to pay back such liabilities within a short time period, typically twelve months. Accordingly, Net Working Capital showcases the ability of your business to pay off its liabilities in a short period of time.

Also, it indicates how much of the long term funds you need to fund your current assets. That is it reflects the portion of your current assets financed with the long-term funds.

Furthermore, it helps in studying the quality of your business’s current assets. This is helpful when your business is not able to pay its creditors. Despite having high amounts of current assets.

Also, the Net Working Capital indicates the short-term solvency of your business. It helps your creditors to know your liquidity position before supplying goods or services on credit to you .

Net Working Capital Example

Say, Jack and Co Pvt Ltd has the following current assets and liabilities on its balance sheet dated 31st December 2019.

Current AssetsAmount
Cash and Cash Equivalents$15,000
Trade Accounts Receivable$60,000
Inventories$50,000
Debtors$10,000
Total$135,000
Current Liabilities
Creditors$15,000
Short-Term Loans$40,000
Total$55,000

As per the above table, the Net Working Capital of Jack and Co Pvt. Ltd. is as follows.

Net Working Capital Formula = Current Assets – Current Liabilities

= (Cash and Cash Equivalents + Trade Accounts Receivable + Inventories + Debtors) – (Creditors + Short-Term Loans)

= $135,000 – $55,000

= $80,000

So, the Net Working Capital of Jack and Co is $80,000. This means this amount is sufficient to pay off the current liabilities. If this figure would have been negative, it would indicate that Jack and Co. did not have sufficient funds to pay off its current liabilities. That is it may be heading towards bankruptcy.

Thus, we can deduce the following from the positive Net Working Capital figure of Jack and Co.

  • Jack and Co. have strong liquidity or solvency position.
  • It has strong goodwill as it makes regular and timely payments to its creditors and other short-term lenders.
  • Jack and Co have creditworthiness that enables them to get a regular supply of goods as well as short-term loans.
  • It can avail of cash discounts as it has a sufficient amount of cash to pay to its creditors.
  • Jack and Co. are in a better state to increase their overall productivity. This is because they have sufficient cash to make payment to labor on time. This helps the firm to enhance the turnover of raw materials into sales.
  • It is in a better position to deal with challenging situations like an increase in raw material prices. This is because it has an adequate amount of working capital to beat the competition.
  • Adequate working capital at Jack and Co’s disposal also contributes to increasing its profitability. This is because adequate working capital is needed to increase its sales revenue.

Why is Net Working Capital Important?

Your business must have an adequate amount of working capital to survive and perform its day-to-day operations. Many industries have a higher percentage of current assets relative to the total assets on their balance sheet.

This is typically the case with the manufacturing units and certain wholesaling and retailing sectors. Therefore, financial managers must develop effective working capital policies to achieve growth, profitability, and long-term success.

Further, excessive investment in your current assets may diminish your business profitability. Therefore, it is important for you to determine the optimal level of working capital. This can be done by achieving a trade-off between liquidity and profitability.

Therefore, let’s understand why it is important to have adequate Net Working Capital.

  • Smooth Operating Cycle

Adequate Net Working Capital ensures that your business has a smooth operating cycle. This means the time needed to acquire raw material, manufacture goods, and sell finished goods is optimum.

In other words, you have the raw material required to manufacture goods without any delays. Furthermore, you collect accounts receivable on time and pay accounts payable when due. Also, you have enough cash to meet your day-to-day business needs.

  • Optimal Return on Investment

An adequate amount of Net Working Capital would ensure that you earn a higher return on the amount invested in your current assets. Such a return would help you to meet your fixed obligations. For example, interest on short-term and long-term loans taken to finance such current assets.

Also, it ensures that your shareholders earn a higher return for every dollar invested in your business.

  • Enhanced Solvency and Creditworthiness

Adequate Net Working Capital ensures the long-term solvency of your business. This is because your business has a sufficient amount of funds to make regular and timely payments to creditors.

Such obligations may include payments for purchasing raw materials, wages, and other operating expenses. Further, it also ensures the creditworthiness of your business. That is timely payment to your creditors and bankers ensures a regular supply of goods and short-term loans.

  • Higher Liquidity

An optimal amount of Net Working Capital brings liquidity to your business. This helps you as a small business to finance your short-term obligations. Typically, small businesses have limited access to external financing sources.

Also, such businesses make payments toward outstanding expenses using cash. Therefore, it is important for small businesses to allocate their resources in a proper way and improve their cash management.

  • Uninterrupted Production

A sufficient amount of Net Working Capital at your disposal helps you to maintain good relationships with your trade partners. This happens due to the timely payments you make to your suppliers and banking partners.

As a result, your suppliers and banking partners offer discounts and extend more trade credit. Such a continuous flow of funds ensures you purchase raw material and produce goods uninterruptedly.

  • Competitive Advantage

An adequate amount of Net Working Capital helps you to face shocks and peaks in demand. That is it will help you to survive crises or increase production. This is in the case demand increases unexpectedly. Besides this, you will be able to sell products to your customers at a discount. This would, thus, give you an edge over your competitors.

Changes to Net Working Capital

As stated earlier, the Net Working Capital is the difference between the current assets and current liabilities of your business. Any change in the Net Working Capital refers to the difference between the Net Working Capital of two executive accounting periods.

As a business, your aim is to reduce an increase in the Net Working Capital. This is because an increase in the Net Working Capital would mean additional funds needed to finance the increased current assets.

For instance, the change in the Net Working Capital would amount to $80,000. This is in case the Net Working Capital at the end of November is $200,000 and at the end of December is $280,000.

This means your business would have to search for additional sources of finance to fund the increased current assets. This you can achieve by either taking additional debt, selling assets or shares, or increasing profits.

Thus, it is important to calculate changes in the Net Working Capital. This is to ensure that your business maintains a sufficient amount of Net Working Capital in each accounting period. Such an optimal level of Net Working Capital ensures that your business is neither running out of funds. Nor, it is keeping its cash idle.

Changes in the Net Working Capital Formula

Changes in the Net Working Capital = Net Working Capital of the Current Year – Net Working Capital of the Previous Year

or

Changes in the Net Working Capital = Change in Current Assets – Change in the Current Liabilities.

Let’s understand how to calculate the Changes in the Net Working Capital with the help of an example.

 

So, let us calculate the Net Working Capital for Microsoft for 2019-2020.

  • Calculate Current Assets for The Current and Previous Year

Current Assets (2020) = Cash and Cash Equivalents + Short-Term Investments + Accounts Receivable + Inventories + Other Current Assets
= $13,576 + $122,951 + $32,011 + $1,895 + $11,482
=$181,915

Current Assets (2019) = Cash and Cash Equivalents + Short-Term Investments + Accounts Receivable + Inventories + Other Current Assets
= $11,356 + $122,463 + $29,524 + $2,063 + $10,146
=$175,552

  • Calculate the Current Liabilities for the Current and Previous Year

Current Liabilities (2020) = Accounts Payable + Current Portion of Long-Term Debt + Accrued Compensation + Short-Term Income Taxes + short-Term Unearned Revenue + Other Current Liabilities
= $12,530 + $3,749 + $7,874 + $2130 + $36,000 + $10,027
= $72,310

Current Liabilities (2019) = Accounts Payable + Current Portion of Long-Term Debt + Accrued Compensation + Short-Term Income Taxes + short-Term Unearned Revenue + Other Current Liabilities
= $9,382 + $5,516 + $6,830 + $5,665 + $32,676 + $9,351
= $69,420

  • Calculate Net Working Capital for Current and Previous Year

Net Working Capital (2020) = Current Assets – Current Liabilities
= $181,915 – $72,310
=$109,605

Net Working Capital (2019) = Current Assets – Current Liabilities
= $175,552 – $69,420
=$106,132

  • Calculate Changes in Net Working Capital

Changes in Net Working Capital Formula = Current Year’s Working Capital – Previous Year’s Working Capital
= $109,605 – $106,132
= $3,473

Net Working Capital Ratio

Net Working Capital Ratio refers to a ratio that includes all the components of your Net Working Capital. It is calculated by dividing the current assets of your business with its current liabilities. This ratio is also called the current ratio. This ratio indicates the liquidity of your business. That is whether you have sufficient funds to run your business operations in the short-term.

A low Net Working Capital Ratio indicates that your business is facing serious financial challenges. This is because it does not have sufficient short-term assets to meet its short-term obligations.

However, a high Net Working Capital Ratio does not mandatorily mean that your business is efficient in managing its short-term finances. It may also mean that your business is holding excess idle cash that could be reinvested into your business itself.

Using the same example of Jack and Co as mentioned above, its Net Working Capital Ratio would be:

= Current Assets/Current Liabilities

= $135,000/$55,000 = 2.45

Besides the above ratio, you can also use another ratio that compares the Net Working Capital of your business to its total assets.

Net Working Capital Ratio Formula = Net Working Capital/Total Assets

= (Current Assets – Current Liabilities)/Total Assets

This ratio indicates the amount of funds invested in fixed assets. An increasing ratio indicates that your business is reducing its investments in fixed assets. And increasing investment in liquid assets.

Pros and Cons of Net Working Capital

Your business must maintain a sound Net Working Capital to run its business operations. Both excessive and inadequate Net Working Capital positions impact your business.

Excessive Net Working Capital implies holding cost and idle funds. However, inadequate Net Working Capital leads to interruptions in production and reduced profitability.

Pros of Net Working Capital

  • Adequate Net Working Capital position indicates the short-term solvency position of your business.
  • It increases your firm’s goodwill as a result of regular and timely payment to creditors
  • A sound Net Working Capital increases the creditworthiness of our firm in the eyes of the financial institutions. This is due to timely payment to bankers or creditors. Also, it enables your firm to get a regular supply of goods and the availability of short-term loans.
  • Strong Net Working Capital Position gives an opportunity to your firm to avail cash discounts. This is because you have sufficient cash at your disposal. And this allows you to make early payments to creditors.
  • Having an adequate amount of Net Working Capital leads to an increase in the overall productivity of your business. This is because you have enough funds to pay wages to labor on time.
  • The sound Net Working Capital position gives you a competitive advantage.
  • Adequate Net Working Capital also helps you to increase the total revenues of your business

Cons of Net Working Capital

Cons of Excessive Net Working Capital

  • Excessive Net Working Capital is not good for your business if it is in excess due to a high amount of inventories. It indicates either obsolete stock or slow sales turnover of your firm.
  • An excessive Net Working Capital indicates that more funds are kept idle for a long period of time. That is at a minimum of up to one operating cycle of your business.
  • Excessive Net Working Capital also showcases that the long term funds which could have been used in buying long-term assets or investments are put on hold.
  • It also indicates managerial inefficiencies like low inventory, high cost of inventory storage, increased bad debts, and losses.
  • Excessive Net Working Capital points out slack in the debt-collection period and loose credit policy of your business.
  • It also indicates inefficient Net Working Capital management, low profitability, and a decrease in the price of your business shares.

Cons of Inadequate Net Working Capital

  • Lower Net Working Capital indicates a decrease in the liquidity position of your business. In other words, it also shows short-term solvency under risk.
  • Ineffective Net Working Capital Management and the following challenges are some of the risks that arise due to a shortfall in Net Working Capital.
    • Production challenge
    • Not being able to pay the creditors on time and decline in creditworthiness of your business
    • Your business would be unable to purchase stock on time to get avail discount in case there is a shortage of funds
    • Inadequate Net Working Capital also reduces the rate of return
    • It indicates your business made huge investments in either long-term assets or investments. But, had no fund left for Net Working Capital Management. This results in losing fixed assets and their efficient utilization.
    • Moreover, it quite difficult for your business to regain its reputation
    • Your labor and employees experience a decline in morale. This is due to irregular remuneration made to them due to lack of funds.

How to Increase Your Net Working Capital?

As mentioned above, a shortfall in the Net Working capital can have a negative impact on your business. Thus, it is always suggested to maintain adequate Net Working Capital. However, you may assume that taking a loan or using a credit line are the ways by which you can resolve the challenge of the inadequacy of the Net Working Capital.

However, there are a number of ways in which you can improve your Net Working Capital Management.

  • Short Operating Cycles

Operating Cycle is nothing but the time duration you need to convert sales into cash once your resources are converted into inventories. This means the operating cycle would come to an end once you receive cash from your customers for the goods sold.

Therefore, it is important to have an optimal operating cycle. So, you may ask your debtors to pay within 15-60 days depending on the industry standards. Remember, you need to reduce the time period between completing production and sending invoices to your customers.

  • Check the Creditworthiness of Customers

You need to keep a check on the credit paying capacity of your customers. This is because you want your customers to clear their invoices on time. Therefore, you need to check the credit score of your customers before entering into any sort of agreement with them.

  • Timely Collection of Invoices

In case your customers make delays in clearing the invoices, you need to ask them to clear their payments at the earliest.

  • Increased Sales

This is an obvious step to change the Net Working Capital of your business. Accordingly, you need to increase your sales team and market your products using various channels. Remember to keep the pricing of your products reasonable.

  • Do Not Pile Inventory

Investing more money in inventory means keeping your cash idle and not putting it to use. Therefore, this results in decreased liquidity and makes your business less competitive. So, it becomes very important to quickly convert inventory into cash.

  • Cut Down Unnecessary Expenses

Create a budget for expenses and report each of the cost components separately. Such a cost budget will help you to locate areas where our business is spending excessively. This will help you to cut down on excessive expenditure.

  • Take Benefit of Accounts Payable

A good credit score can go a long way in maintaining good relationships with creditors and bankers. This is because you can get loans and trade credit on attractive terms from bankers and creditors.

Information may be abridged and therefore incomplete. This document/information does not constitute, and should not be considered a substitute for, legal or financial advice. Each financial situation is different, the advice provided is intended to be general. Please contact your financial or legal advisors for information specific to your situation.

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