What is Net Working Capital?
Net working capital is defined as the difference between the current assets and current liabilities of a business. It is the part of the current asset left after paying off all the current liabilities. Also, it is one of the important parameters for evaluating a firm’s financial position or stability. Positive net working capital represents the ability of the business to pay off its liabilities. On the other hand, negative net working capital is a concern. At first sight, it gives an idea about the firm’s ability to pay off its short-term debts. The solvency of a firm depends more on short-term liquidity than on longer-term debts. Therefore, it is essential to keep a continuous watch over the net working capital.
How to Calculate Net Working Capital?
The calculation involves current assets and current liabilities. The formula for it is as follows:
Formula for Net Working Capital
|Net Working Capital||=||Current Assets – Current Liabilities|
The current assets include all those items which are either cash or can be converted into cash in a short period of time or immediately. This period is generally considered a year. Although the following list cannot be comprehensive, we have tried to cover most of them. Current Assets include the following items:
- Inventory / Stock
- Debtors and Bills Receivables
- Cash and Bank Balances
- Short Term Loans
- Marketable Investment / Short-Term Securities
It should be noted that just including the above items in calculating NWC will not produce effective results. Instead, we should analyze the items to understand their convertibility into cash. If a current asset says a debtor, which we have shown in our balance sheet, is going to default, and that money is not about to be realized. It is pointless to include that in our calculation because it is not convertible into cash. In its true sense, it’s not an asset itself.
The same is the case with current liabilities. Current liabilities are those liabilities that are payable in a year’s time. Current Liabilities include the following items:
- Sundry Creditors
- Outstanding Expenses
- Short Term Loans and Advances
- Bank Overdraft / Cash Credit
- Provision for Taxation
- Proposed Dividend
- Unclaimed Dividend
Interpretation of Net Working Capital (NWC)
It is not a ratio but an absolute value if we see it technically. It’s a measure of the liquidity position of a business. For a healthy financial liquidity position, a positive net working capital is a must. Whereas, the negative net working capital suggests that the firm is not capable of paying off its short-term obligations.
|Particulars||Firm A||Firm B|
|New Working Capital||1,000,000||150,000|
In the above example, Firm A has a much higher NWC than Firm B. Can we say that Firm A stands better in terms of liquidity? Let’s look at it the other way round. Comparing current assets and liabilities, we observe, Firm B has $ 2 assets to pay off each liability while Firm B has just $ 1.25. It is clear from the above that the liquidity position of Firm B is better compared to Firm A.
Even if we notice the significant increase in the NWC of Firm A in the next year, we cannot say that its liquidity position has improved. Commenting on the liquidity position of a business or firm would necessitate a comparison between current assets and current liabilities. The current ratio, quick ratio, and absolute cash ratio are better measures of the liquidity position of a firm.
Continue reading about other Types of Working Capital.