Net working capital (NWC) is significant for a business, or we can say it is the lifeline of a company. It allows the company to meet its short term expenses, or run its operations smoothly. The formula to calculate net working capital is current assets less current liabilities. Changes in the net working capital, on the other hand, is the difference between the NWC of any two periods -years or quarter or month.
A business needs to calculate this change to make sure that it has sufficient working capital, or there is no shortage of funds. Sometimes calculating just an increase or decrease in the working capital does not give a clear picture.
For instance, if a company is in a growth phase, its short-term liability would increase. However, it is not bad for the business. Thus, to get a clear image of the company’s cash, we need to calculate changes in net working capital.
Changes in the Net Working Capital – How to Calculate?
Formula to calculate changes in net working capital is – Working Capital of current year Less Working Capital of Last Year.
Another formula is – Change in Current Assets of two periods Less Change in Current Liabilities of those two periods.
Now, let’s look at the steps to calculate changes in net working capital:
First, calculate the total amount of current assets for the current and previous year using the balance sheet figures.
Second, calculate the total amount of current liabilities for the current and previous year using the balance sheet figures.
Third, use the above two to get the net working capital for the current and previous year.
Fourth, now use the formula above to calculate the changes in the working capital.
Let us consider an example to understand the calculation better.
Company A has current assets of $20,000 and a current liability of $10,000 for the year 2020. The current asset and current liability for 2019 were $15,000 and $8,000, respectively.
For the year 2019, the net working capital was $7,000 ($15,000 Less $8,000).
For year 2020, the net working capital is $10,000 ($20,000 Less $10,000).
Now, changes in net working capital are $3,000 (10,000 Less $7,000).
In this case, the change is positive, or the current working capital is more than the last year. It means Company A would have to find ways to fund this increase. It may sell shares, take on more debt, or sell assets to meet the increase in the working capital.
- A business will witness no change in the working capital if the current assets and liabilities increase by the same amount.
- If the change is positive, it could mean that the current assets in the current period have increased more than the corresponding change in the current liabilities.
- Conversely, if the change is negative, it would mean that the current liabilities have increased more than the corresponding change in the current assets.
Working capital is a good measure of liquidity. A firm with positive working capital, i.e., having more current assets than current liabilities, would be able to cover its short-term expenses and would continue its operations comfortably. However, if the variation between the current assets and current liabilities is too much, it could mean the underutilization of resources. Similarly, negative working capital (current liabilities more than current assets) is not always bad. It could mean the company is growing.
On the same line, change in the net working capital gives us an idea of the cash position of a company. If the change is positive, it would mean there is more cash outflow in the form of more current assets. If the difference in the net working capital is negative, it would mean that current liabilities have increased more, such as an increase in bills payables. So, this would mean a cash inflow.
Factors Affecting Working Capital
Following factors results in an increase or decrease in the working capital:
- If a company follows a lenient credit policy, it will increase its accounts receivables. A strict credit policy would result in a decrease in accounts receivables, but it negatively affects sales.
- A company with too much inventory has more working capital. Or, we can say, a rise in stock raises the cash outflow.
- Delaying accounts payable also affects the changes in working capital.
- A high-growth company will need more cash to buy inventories. Also, it would have more account receivables.
- A company that buys in larger volumes to reduce the unit cost would need more funds.
Following points reflect the importance of changes in the net working capital:
- It is a relevant part of the statement of cash flows and indicates the operating cash flow.
- Changes in the working capital is an essential input for valuing a company.
- It also suggests if the current assets are rising or dropping in proportion to the current liabilities or not.
- An increase in the NWC would mean a better liquidity position. It could also mean that the firm is effectively exploiting its existing resources.
- It helps to answer an important question – does the business needs more cash as it grows, or it generates more money as it grows.
Calculating changes in net working capital from one period to another is significant for a company to get a clear image of its cash position. Moreover, it is equally vital for a company to track those changes to manage its operating cash flows properly. A consistent positive change should ring the alarm bells that cash balance is reducing. If the company does not take necessary actions, then it may have to sell assets or use other sources of funds to continue the operations.