What is net working capital and how to calculate it from balance sheet?
A major driving force to your business is the net working capital. This capital - also referred to as NWC - is the total amount of assets that are easily accessible to a business, at any given time. These assets are used by the business to cover their short-term debts, payments, and any liabilities they may have.
Working capital accounting is crucial to know where the business stands since it is its main source of payable. A change in the net working capital can have a remarkable effect on the business's financial health and performance. That is why it becomes important to understand what net working capital is, how to calculate it, and what changes it can undergo. Once you understand that, you can then focus on improving your NWC.
Net working capital refers to the accessible assets of a company. Looking at it mathematically, it is actually a ratio that defines the difference between an organization’s assets and its liabilities. The NWC appears on a company’s balance sheet. The main goal of capital is to determine how liquid a company’s assets are at any given point. This liquidity will define the company’s ability to meet its dues and business expenses.
Net working capital can be positive, negative, or “net-zero”. A positive net working capital is one where the company can meet its obligations while still having remaining funds for investments, expansion, extended operations, and even emergencies.
Conversely, a negative NWC is when a company’s liabilities are far greater than what it can afford to pay. In a situation like this, the company would need to secure investments to avoid going bankrupt. A net-zero NWC is when the company can meet its liabilities but doesn’t have any additional funds for non-essential expenses in the pipeline.
The task of calculating net working capital is not that difficult. It simply requires the organization of all your current assets and your current liabilities. This is where accurate working capital accounting can help you.
Before you even start to calculate your NWC, you should list all your assets and liabilities. Then you need to categorize them as long-term or short-term. In general, long-term debts do not constitute liabilities that affect net working capital. Similarly, intangible assets do not contribute to increasing your working capital.
The first step is to calculate your current assets. These include your inventory, your accounts receivable, as well as any cash you may have (or cash-adjacent assets, like the company’s bank balance). If you’re unsure about what constitutes an asset, then there is a simpler way to recognize it. If an asset can be liquidated within a year’s time without having a major negative impact or considerably high cost (which could turn into a liability), then it is a current asset.
The second step is to calculate your current liabilities. These are usually listed in your NWC balance sheet, alongside your assets. Any payment that is due within a twelve-month period is considered a liability. Examples of liabilities that affect your working capital are accounts payable, short-term loan repayments, payroll dues, or inventory dues.
Once you have a clear list of your liabilities and assets, you just need to reduce the former from the latter. The simplistic formula for calculating net working capital is
Net Working Capital = Current Assets - Current Liabilities.
If you are trying to gauge your net working capital ratio, then you need to divide instead of reducing.
Net Working Capital Ratio: Current Assets / Current Liabilities.
Before you go on calculating your net working capital, though, consider why you are making this calculation. Depending on the objective of the analysis, your formula might be tweaked. For instance, if you are only looking at the capital gains and losses from your payable bills, then the only difference you need to calculate is the difference between accounts payable and accounts receivable.
A good net working capital ratio is indicative of your company’s financial health. It depicts the balanced manner in which a business manages its debts, while also putting enough cash into long-term investments for the scaling of the business. An extremely high working capital only shows that a business is not using its profits well. The excess cash can be used for investing in inventory, expansion, or even human capital. On the other hand, a very high list of debits is indicative of a business that is struggling to have good cash flow.
But these are only the outside inferences of the working capital. Internally, your working capital tells you where you stand financially. It helps you ascertain all the assets you have that can be liquidated. It also gives you a better understanding of how you intend to repay your dues. Your NWC balance sheet becomes a contributing factor to your financial decisions for the upcoming year.
The goal, for any business’ financial team, is to have a working capital that is above “net zero” but not flush with cash. The idea is to have enough to pay all loans, while also leaving room to grow profitably and invest in high-return ventures.
The status of a company’s credit line can have an impact on the net working capital. Your credit line is definitely an asset - but instead of the total credit amount, it is the balance that goes towards counting the asset. This is because an exhausted credit line cannot pay any dues, and becomes a liability instead. Credit lines can only fund short-term debts and should be treated as such.
Like any accurate data analysis, standard deviations give a better understanding of how the data functions. In the case of net working capital, these are anomalies in payments. For instance, a large account receivable payment that only takes place once a year is not an accurate depiction of the net working capital. Neither is a large payable that only takes place bi-annually.
If an asset is not liquid, or cannot be liquidated on demand, then it cannot be considered as part of the working capital. Sometimes liquidation can come at a great cost to the company. These are all factors that determine whether something can be included in working capital. Even account receivables that are delayed, or have longer payment terms, end up being excluded from a company’s assets since they are not accessible.
Inventory performance is a major factor that impacts working capital. The excessive stock of products is a liability more than it is a profit-turning device. Making sure that your warehouses or inventory have a consistent flow of materials incoming and product outgoing can help provide a steady stream of profitable income. On the other hand, the inability to move stock ends up creating higher dues that drain the cash flow. This cash flow can directly benefit or harm the working capital of your company.
It is important to understand that short-term debts constitute liabilities in the calculation of the working capital. However, long-term debts do not. This is because long-term debts are expected to be paid off over a longer period of time with no immediate cut into the assets. On the other hand, short-term debts can end up causing a major burden. The status of long-term and short-term debts can affect your working capital majorly.
A positive net working capital means that the company is able to pay all its debts without having to take on further loans or investments. The company has enough cash to repay its dues, while also focusing on improving the business.
A negative working capital, on the other hand, is indicative of a company that is struggling to repay its debts. The liabilities are far greater than how liquid the business is. It can be seen in excessive deferred payments, too many invoice extensions. Salaries and business expenses are badly affected.
Sometimes, simply having a number for working capital is not helpful. It can also be useful to know the net working capital ratio (the ratio of assets to liabilities). A ratio of 1.2-2.0 means a positive working capital. Anything lower than 1 (net zero working capital) means a negative working capital.
Your working capital does not remain static. Given that it is subject to only short-term assets and liabilities, it is bound to change every few months. These changes can be profitable or detrimental, depending on what factors have contributed to the change. But a change is a good thing because it shows that your business has not reached stagnation. Efficient working capital accounting helps analyze this change.
Calculating the change in net working capital is simple enough. You simply need to find the difference between the working capital for this year and the working capital of the previous year. Alternatively, you can calculate the difference between the assets and liabilities from the previous year and the current year. The difference in liabilities can be subtracted from the difference in assets.
An example of this can help understand the concept better. Consider a company PQR, which works in the fashion industry.
In order to calculate the change in their working capital, the following steps need to be taken:
1. Look at the working capital for 2020. It requires the liabilities (accounts payable and payroll) to be subtracted from the assets (accounts receivable, inventory, cash). The working capital for 2020 is (30000 + 6000 + 11000) - (8000 + 7000) = 32000
2. Then, look at the working capital for 2021. The working capital for 2021 is (40000 + 6500 + 15000) - (9000 + 9000) = 43500
3. The change in working capital, i.e the cash outflow, is the difference between the two (11500)
The beauty of net working capital is that it can always be improved. If your NWC balance sheet is becoming a cause for concern, then there are multiple ways in which you can improve the total at the bottom.
One way is to always follow up on your payments. If you have a high volume of these, then using an expense management system like Volopay, is ideal. The software can set up reminders for your clients to pay their dues as soon as an invoice is received and/or closer to the payment date. It acts as a data collection and assortment software, which also does your working capital accounting. If your clients are paying on time, but your NWC balance sheet isn’t improving, then it might be the payment cycle that needs to be revised. Switching to a shorter payment cycle can help.
On the opposite side of this spectrum, trying to lengthen your payment cycle for vendors can improve your working capital. Reach out to your vendors for longer payments plans so that your dues are better spread out. It’s also good to consult them for discounts. Many vendors offer discounts for early or timely payments. Volopay is tied up with multiple vendors who offer such competitive prices.
If your trouble is moving stock, then you need to relook at your inventory. Slowing down incoming materials can help reduce costs to vendors. At the same time, pushing stock at a quicker rate can increase the customer base and the orders in the pipeline. When reworking your inventory, if certain assets are simply dead weight (like unused machinery), then sell them for liquidation. You can even return unused inventory to receive refunds that aid your working capital.
In theory, net working capital and working capital are phrases that can be used interchangeably. Both refer to the ability of a company to pay its dues. But some financial analysts draw a difference between the two for more accuracy.
The formulae used by these analysts narrow down the definition of net working capital. One of the formulae does not consider cash in the assets, and also excludes debt from liabilities. Another formula only focuses on accounts payable, accounts receivable, and inventory.
The definition that applies to your business will depend on what the NWC is being used to gauge and use the relevant formula accordingly.