Net working capital is defined as the difference between the current assets and current liabilities of a business. It is that part of the current asset which is left after paying off all the current liabilities. 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.
Net working capital is one of the important parameters for evaluation of a firm’s financial position or stability. At the very first site, it gives an idea about the firm’s ability to pay off its short-term debts. Solvency of a firm depends more on the short-term liquidity rather than on longer-term debts. It is therefore very essential to keep a continuous watch over the net working capital.
How to calculate Net Working Capital?
The net working capital calculation involves current assets and current liabilities. Formula for net working capital is as follows:
|Net Working Capital||=||Current Assets – Current Liabilities|
- 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 above items in the calculation of net working capital will not produce effective results. Rather, we should analyze the items to understand its 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.
Same is the case with current liabilities. Current liabilities are those liabilities which are payable in a year’s time. Current Liabilities include 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)
If we see technically, it is not a ratio but an absolute value. It’s a measure of liquidity position of a business. For a healthy financial liquidity position, at least, a positive net working capital is a must. Negative net working capital suggests that the firm is not capable enough to pay off its short-term obligations.
|Firm A||Firm B|
|New Working Capital||1,000,000||150,000|
Even if we notice the significant increase in the net working capital of Firm A in the next year, we cannot say that its liquidity position has improved. Commenting on liquidity position of a business or firm would necessitate comparison between current asset and current liabilities. Current ratio, quick ratio and absolute cash ratio are a better measure for liquidity position of a firm.