Net Working Capital

Updated on May 13, 2024
Article bySayantan Mukhopadhyay
Reviewed byDheeraj Vaidya, CFA, FRM

What Is Net Working Capital?

In simple terms, net working capital (NWC) denotes the short term liquidity of a company. It is calculated as the difference between the total current assets and the total current liabilities.

What Is Net Working Capital

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Source: Net Working Capital (wallstreetmojo.com)

This metric is an important indicator of business performance. A good level of the above indicates that the business has enough liquidity to meet the current financial obligation, which is extremely important to run daily operations smoothly. A fall in the amount of this capital is detrimental to the entity and leads to doubt about the efficiency of the management.

Key Takeaways

  • Net working capital, or NWC, indicates a company’s short-term liquidity. It is the difference between the total current assets and liabilities.
  • Current assets and liabilities are critical net working capital formula elements.
  • If this working capital is positive, the investors must know that the company has sufficient current assets to clear its liabilities.
  • If it is negative, the investors must understand that the company does not have enough assets to cover its current liabilities. It can also be used to calculate the free cash flow to the firm and the free cash flow to the equity

Net Working Capital Explained

The net working capital calculation is an essential financial metric used to measure the deviation or divergence between an entity’s current assets and current liabilities. Every business enterprise extensively uses this metric to understand the economic or financial condition of the enterprise.

The terms working capital itself signifies the amount of fund that the company possess at a point of time to meet the current financial obligations, without which the daily needs to the business cannot be satisfied. However, the net amount is calculated by deducting the current liabilities form the assets, which gives a clear idea about the funds available.

This value can be positive or negative, depending on the condition of the business. If it is positive, implying more of assets than liabilities, it is good for the company, since it has more funds to pay off its current debts. If the situation is opposite, then ift signifies poor financial health. It indicates that the company has liquidity issues. In this way the change in net working capital is interpreted.

Different companies may have different level of liquidity requirements, depending on the type of industry, business model, products and services manufactured etc. It also depends on the market conditions and the size of company operations.

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Net Working Capital Explained in Video

 

Formula

Let’s have a look at the formula used for net working capital calculation

Net Working Capital fomula

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There are two important elements.

  • The first element is the current assets. Current assets are those assets that can liquidate within one year or less. That means current assets will pay you off for less than a year. We can give examples of current assets as sundry debtors, accounts receivables, inventories, prepaid salaries, etc.
  • The second element is the current liabilities. Current liabilities are those liabilities that can pay off for less than a year. Examples of current liabilities are sundry creditors accounts payables, outstanding rent, etc.

How To Calculate?

Let us identify the steps that are commonly used to calculate the value if net working capital. They are as follows:

  • Gather necessary information – The first step in the net working capital equation is to accumulate all the important information that can and should be used for the calculation. They are acquired from the financial statements and annual reports.
  • Identify the current assets -It is necessary to be able to identify the current assets correctly. They are the ones that are the most liquid assets, which include cash, receivables, inventory, prepaid expense, investments made for short term, etc.
  • Identify current liabilities – Just like the above step, this too involves noting the liabilities that need to be settled within one year or within normal operating cycle, like accounts payable, short term debts, accrued expense.
  • Applying the formula – This step involves deduction of current liabilities from the assets so as to arrive at the correct value of the net working capital.

The above steps are commonly used by the management and stakeholders to calculate the value of net working capital equation. However, it is a very complex process, where the change in net working capital is more in case the company is bigger, covering a wider market and wide range of products and services.

Example

Let’s take a practical example of networking capital formula.

Example#1

Tully Company has the following information –

  • Sundry Creditors – $45,000
  • Sundry Debtors – $55,000
  • Inventories – $40,000
  • Prepaid salaries – $15,000
  • Outstanding advertisements – $5000

Find out the NWC of Tully Company.

We have been given both current assets and current liabilities in the above example.

First, we need to separate the current assets from the current liabilities.

Then we need to total the current assets and also the current liabilities. And then, we need to find the difference between the current assets and the current liabilities as per the net working capital equation.

  • Current Assets – Sundry Debtors, Inventories, Prepaid salaries;
  • Current Liabilities – Sundry Creditors, Outstanding advertisements.

Total current assets = (Sundry Debtors + Inventories + Prepaid salaries) = ($55,000 + $40,000 – $15,000) = $110,000.

Total current liabilities = (Sundry Creditors + Outstanding advertisements) = ($45,000 + $5000) = $50,000.

The Net Working Capital Formula is –

Example#2

Below is the Balance Sheet Snapshot of Colgate’s 2016 and 2015 financials.

Net Working Capital - colgate

Let us do the Calculation for Colgate

NWC (2016)

  • Current Assets (2016) = 4,338
  • Current Liabilities (2016) = 3,305
  • NWC (2016) = 4,338 – 3,305 = $ 1,033 million

NWC (2015)

  • Current Assets (2015) = 4,384
  • Current Liabilities (2015) = 3,534
  • NWC (2015) = 4,384 – 3,534 = $850 million

Uses

Investors use NWC to know whether a company is liquid enough to pay off its short-term liabilities. If you look at current assets and current liabilities, you will find them on the balance sheet. That’s why NWC needs to be interpreted properly.

There are two ways through which we can interpret NWC.

  • When the net working capital adjustment is positive, the investors can understand that the company has enough current assets to pay off its current liabilities.
  • And when the NWC is negative, the investors can comprehend that the company doesn’t have enough assets to pay off its current liabilities.

Investors can also see the usefulness of NWC in calculating the free cash flow to firm and free cash flow to equity. But if there is an increase in the net working capital adjustment, it isn’t considered positive; rather, it’s called negative cash flow. And obviously, this increased working capital is not available for equity.

Calculator

You can use the following calculator

Total Current Assets
Total Current Liabilities
Net Working Capital Formula
 

Net Working Capital Formula = Total Current Assets Total Current Liabilities
0 0 = 0

Formula In Excel (with excel template)

Let us now do the same example above in Excel. It is very simple. You need to provide the two inputs of Total Current Assets and Total Current Liabilities.

You can easily do the Calculation in the template provided.

First, we need to separate the current assets from the current liabilities.

Net Working Capital formula in excel

Net Working Capital Vs Gross Working Capital

The above are significantly related and commonly used to measure the business’s financial health. However, some differences between them are as follows:

  • The former focus on the differences between the assets and liabilities that are current in nature while the latter focus only on the total value of the current assets.
  • The former represents the funds available to meet the current obligations whereas the latter represents the funds invested only on current assets.

Thus, both are equally important while evaluating the company’s financial condition.

Frequently Asked Questions (FAQs)

What is a good ratio for net working capital?

A favorable net working capital ratio is 1.5 to 2.0, depending on the industry the business is in. Therefore, to adequately interpret a financial ratio, a company should have comparative data from previous periods of operation or its industry.

What is a good ratio for net working capital?

A favorable net working capital ratio is 1.5 to 2.0, depending on the industry the business is in. Therefore, to adequately interpret a financial ratio, a company should have comparative data from previous periods of operation or its industry.

How to improve net working capital?

Improving net working capital requires a combination of compelling accounts receivable management, efficient inventory management, negotiating better terms, reducing operating expenses, and selling off unnecessary assets.

This article has been a guide to what is Net working Capital. We explain it with formula and how to calculate it with example and calculator. Here you also find Net Working Capital Calculator and an excel template download.  You may also have a look at the following articles to learn more about Financial Ratio Analysis –