Net Working Capital – calculation, Formulas, Pros and Cons

No matter what type of business you own or what methods you pursue to forecast sales, revenue or expense, when the question of determining the overall health of an organization comes, companies rely on one fundamental value – net working capital. Managing finance and expenses is a core responsibility of owning or operating any sort of business.

It is critical for small to medium-sized businesses to keep a close record of their expenses, investment and finances. The article is all about what is networking capital and how and why should we calculate it to forecast the future of the firm.

What is net working capital?

Net working capital is used to measure the liquidity of a firm and gives an impression on how efficiently a business uses its assets. Simply put, it is the value we get after subtracting total current assets from total current liabilities.

Positive net working capital: it indicates a firm has enough short term funds available to pay for future current liabilities.

Negative net working capital: it indicates a firm does not possess adequate funds to pay for future current liabilities.

The networking capital also forecasts the ability of a firm that how quickly it can grow, how much cash reserves it possesses to scale up the business in years to come. Another more important indicator of a company’s growth is when account receivable payment terms are sustainably shorter than account payable terms.

What are the formulas to calculate net working capital?

In order to forecast NWC, below is the listed assumption we use. These common drivers will let you calculate the value for NWC

  • Account receivable
  • Current assets
  • Inventory
  • Account payable
  • Other current liabilities

AR days, AP days and inventory rely on sales or CGS to calculate, if neither of the value is available, you can analyze the past values to estimate the future trends.

You can calculate net working capital value through different methods or formulas; mainly contingent upon the analyst – whether he wants to include or exclude a particular value.

NWC = current assets – current liabilities

Or

NWC = AR (account receivable) + inventory – AP (account payable)

What are the advantages of networking capital

  • The positive value ensures you have enough funds to meet your current liabilities and also you can survive in slow years.
  • The extra amount can be invested wither in the short term or long term securities.

What are the disadvantages of positive net working capital

  • A substantially positive value indicates you are not using your short term assets effectively.
  • You cannot always count on networking capital value for liquidity purposes because some assets cannot be converted to cash so easily.

What are the possible ways to increase networking capital value

Here are some foolproof ways that can help you improve the NWC’s value.

Improve inventory turnover

Put serious consideration and find ways to gradually increase inventory turnover.

Sell unused long term assets

If your company has unused long term assets, consider selling them for cash. It will eventually increase net working capital because types of equipment are long term assets and you don’t incorporate them in your current assets.

Refinance short term debt

Short terms debts are due one or less than one year. When you refinance short term debt with long term security, it eventually improves NWC’s value since long term debts will not remain the part of networking capital.

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