What is net working capital?
Let's unravel the enigma of this confusing finance term.
Net working capital (NWC) is a crucial financial metric that assesses a company's liquidity, or its ability to meet its short-term obligations.
It's calculated as the difference between current assets (those that can be converted into cash within a year) and current liabilities (debts that must be paid within a year).
Why is NWC Important?
NWC serves as a key indicator of a company's financial health.
A positive NWC indicates that a company has sufficient resources to cover its short-term debts and maintain operations smoothly.
Conversely, a negative NWC suggests that a company may struggle to meet its obligations and may face potential financial difficulties.
There are three main ways to calculate net working capital (NWC):
Current Assets - Current Liabilities
This is the most common method and is also the one that is used in financial statements.
Current assets are assets that can be converted into cash within one year, while current liabilities are debts that must be paid within one year.
Accounts Receivable + Inventory - Accounts Payable:
This method is more focused on the operating cycle of a business, which is the time it takes to convert cash into inventory, sell inventory, and collect cash from customers.
Accounts receivable are the amounts owed to the company by its customers, inventory is the goods that the company has on hand for sale, and accounts payable are the amounts owed to the company by its suppliers.
Non-cash Working Capital:
This method excludes cash from the calculation of net working capital. This can be useful for comparing the financial health of companies that have different levels of cash on hand.
Here is an example of how to calculate net working capital using each of the three methods using
as our guinea pig, all numbers in billions.
Current Assets - Current Liabilities
??Current assets: $176.3
??Current liabilities: $86.3
= Net working capital: $90
Accounts Receivable + Inventory - Accounts Payable
Accounts receivable:
??Accounts Receivable: $41
??Inventory: $2.9
??Accounts payable: $5.8
= Net working capital: $38.1
Non-Cash Working Capital
??Current assets: $176.3 (minus cash) $119.9
??Current liabilities: $86.3 (minus debt) $3.1
= Net working capital: ($27.2)
The choice of which method to use depends on the specific circumstances of the company being analyzed.
These are the foundations of the formulas, but of course you can adjust as needed.
However you choose to go, all three methods provide a useful measure of a company's liquidity, which is its ability to meet its short-term obligations.
