What Is Working Capital?
Working capital, also known as net working capital (NWC), is the difference between a company’s current assets—such as cash, accounts receivable/customers’ unpaid bills, and inventories of raw materials and finished goods—and its current liabilities, such as accounts payable and debts.
NWC is a measure of a company’s liquidity, operational efficiency, and short-term financial health. If a company has substantial positive NWC, then it should have the potential to invest and grow. If a company’s current assets do not exceed its current liabilities, then it may have trouble growing or paying back creditors. It might even go bankrupt.
- Working capital, also called net working capital (NWC), represents the difference between a company’s current assets and current liabilities.
- NWC is a measure of a company’s liquidity and short-term financial health.
- A company has negative NWC if its ratio of current assets to liabilities is less than one.
- Positive NWC indicates that a company can fund its current operations and invest in future activities and growth.
- High NWC isn’t always a good thing. It might indicate that the business has too much inventory or is not investing its excess cash.
Understanding Working Capital
NWC estimates are derived from the array of assets and liabilities on a corporate balance sheet. Current assets listed include cash, accounts receivable, inventory, and other assets that are expected to be liquidated or turned into cash in less than one year. Current liabilities include accounts payable, wages, taxes payable, and the current portion of long-term debt that’s due within one year.
To calculate NWC, compare the former with the latter—specifically, subtract one from the other. The standard formula for NWC is current assets minus current liabilities. A company has negative NWC if the equation produces a negative number or if its working capital ratio, which is current assets divided by current liabilities, is less than one.
In the corporate finance world, “current” refers to a time period of one year or less. Current assets are available within 12 months; current liabilities are due within 12 months.
Positive NWC indicates that a company can fund its current operations and invest in future activities and growth.
NWC that is in line with or higher than the industry average for a company of comparable size is generally considered acceptable. Low NWC may indicate a risk of distress or default.
Most major new projects, such as an expansion in production or into new markets, require an investment in NWC. That reduces cash flow. However, cash flow will also fall if money is collected too slowly or sales volumes are decreasing, which will lead to a fall in accounts receivable. Companies that are using NWC inefficiently can boost cash flow by squeezing suppliers and customers.
On the other hand, high NWC isn’t always a good thing. It might indicate that the business has too much inventory or is not investing its excess cash.
How do you calculate net working capital (NWC)?
Net working capital (NWC) is calculated by taking a company’s current assets and deducting current liabilities. For instance, if a company has current assets of $100,000 and current liabilities of $80,000, then its NWC would be $20,000. Common examples of current assets include cash, accounts receivable, and inventory. Examples of current liabilities include accounts payable, short-term debt payments, or the current portion of deferred revenue.
What is an example of NWC?
Consider the case of XYZ Corp. When XYZ first started, it had NWC of only $10,000, with current assets averaging $50,000 and current liabilities averaging $40,000. To improve its NWC, XYZ decides to keep more cash in reserve and deliberately delay its payments to suppliers to reduce current liabilities. After making these changes, XYZ has current assets averaging $70,000 and current liabilities averaging $30,000. Therefore, its NWC is now $40,000.
Why is NWC important?
NWC is important because it is necessary for businesses to remain solvent. In theory, a business could become bankrupt even if it is profitable. After all, a business cannot rely on paper profits to pay its bills—those bills need to be paid in cash readily in hand. Say a company has accumulated $1 million in cash due to its previous years’ retained earnings. If the company were to invest all $1 million at once, it could find itself with insufficient current assets to pay for its current liabilities.