Net Working Capital (What It Is And How It Works: Overview)

What is Net Working Capital?

How does it work and why is it important?

What are the essential elements you should know!

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What Is Net Working Capital

In accounting and business finance, net working capital, also referred to as “working capital” or “NWC”, refers to the difference between a company’s current assets and current liabilities on its balance sheet.

In essence, the net working capital is an accounting or financial measure of a company’s liquidity allowing it to meet its short term debt obligations with assets available on the short term.

The current assets can include:

• Cash 
• Account receivables
• Inventory 

The current liabilities can include:

• Accounts payable 
• Accrued expenses 

The more a company has a positive working capital, the more the company is able to meet its operational expenses in the short term.

On the other hand, a company that has a negative net working capital will have trouble paying its accounts payable and operational expenses in the short term thereby affecting its growth and potential profitability.

Too much working capital may not necessarily be good for business either.

For instance, a company with too much working capital is either holding too much inventory or is not investing its available cash into business projects to generate more business income.

Accountants and business finance professionals calculate net working capital with the objective to determine what is a healthy threshold for the company to maintain.

Net Working Capital Definition

According to the Corporate Finance Institute, net working capital is defined as:

The objective of determining the net working capital is to assess and measure a company’s liquidity and ability to meet its short-term obligations using its most liquid assets.

Current Assets

Current assets are short-term assets found on a company’s balance sheet.

When we say “short-term”, we are referring to assets that are highly liquid within a one year period or less such as:

• Cash
• Cash equivalents
• Treasury bills
• Short-term bonds 
• Commercial paper
• Money market funds 
• Marketable securities
• Accounts receivable
• Inventories 

Current Liabilities 

Current liabilities are short-term debt or financial obligations due within a one year period or less and can include:

• Short-term loans
• Lines of credit
• Accounts payable
• Accrued liabilities
• Credit card debt
• Trade debt
• Vendor notes 
• Current portion of long-term debt or loans

What Is The Net Working Capital Formula

To better understand the concept, it’s worth looking at the working capital formula.

To calculate a company’s working capital, you’ll need to perform the following calculation:

Current Assets include:

• Hard cash in company’s bank accounts
• Company’s accounts receivable
• Company’s inventory
• Marketable securities or investments expected to be turned into cash within a year 

Current Liabilities include:

• Accounts payable 
• Wages
• Rent 
• Taxes payable
• Debt obligations that are due within a year
• Accrued expenses 
• Current portion of deferred revenues 

When we refer to “current” assets or “current” liabilities, we are referring to the liquid assets the company expects to have within the next twelve months and the debt obligations it expects to pay within the same period of time.

A variation of the working capital formula is to remove cash from the current assets and debt from the current liabilities:

How To Calculate Net Working Capital

To calculate the net working capital, you’ll need to determine your company’s current assets and current liabilities.

Once you calculate the total current assets and you subtract the total current liabilities from it, the result will be the company’s working capital.

Let’s look at an example.

Let’s assume that the company has the following current assets:

• Accounts receivable: $50,000
• Inventory: $150,000
• Liquid assets: $400,000

The company’s current liabilities are:

• Accounts payable: $100,000
• Wages: $25,000
• Short term debt obligations: $75,000

Based on this, the company’s total current assets equates to $600,000 and the total current liabilities amount to $200,000.

In this example, the company’s working capital is therefore $400,000 ($600,000 – $200,000 = $400,000).

Net Working Capital Ratio

You can calculate a company’s “net working capital ratio” representing a measure of the company’s liquidity and short-term financial health.

You can calculate the “working capital” ratio using the following equation:

You can calculate the “working capital” ratio using the following equation:

A financial ratio for working capital above 1.0 means that the company has more current assets to cover every dollar of current liability.

Conversely, a company’s working capital ratio below 1.0 means that for every dollar of current liability, the company has a deficit in current assets to cover the short-term debt.

Maintaining a positive NWC ratio is important for a company as it demonstrates it has sufficient short-term assets to pay for its short-term financial obligations.

Change In Net Working Capital

How can a company improve its working capital?

What would a change in NWC mean for a company?

A change in the net “working capital” can result from the taking on of new business projects or other factors affecting the business.

One notable reason why a company may experience a change in working capital requirements is when it invests in a new product line, line of business, or penetrates a new market.

When a company expands business operations, it will need to fund the new operations in the short-term and that’s when the working capital is key.

With a business expansion, a company will see a reduction in working capital leading to further investment requirements in NWC.

If the company’s new project is profitable, then the cash flow generated will help replenish the working capital or allow the company to generate sufficient cash to reinvest in the business.

On the other hand, if the company’s new product line is not successful, the company may suffer a cash flow drain and reduction in its working capital.

Here is how you can calculate the change in net working capital:

Let’s look at an example of how a company may achieve a change in its net working capital by keeping more cash reserves and delaying the payment of its accounts payable.

Imagine a company has $20,000 in WC, has an average cash current asset of $100,000 and current liabilities of $80,000.

By increasing its cash reserves and forcing its suppliers to accept payment on their account later, the company can increase its working capital.

Let’s assume that after the implementation of the company’s changes, it has an average working capital of $100,000 and current liabilities of $60,000 resulting in NWC of $40,000.

Working Capital vs Net Working Capital

What is the difference between net working capital vs working capital?

Although the two terms may be used interchangeably, there may be a slight nuance.

When you refer to the “working capital”, many tend to refer to “current assets” or the short-term assets available to a company in nominal value.

On the other hand, when referring to “net” working capital, we are referring to the difference between the current asset and the current liability.

The “net” working capital provides a measure of a company’s liquidity whereas the “working capital” alone merely provides a snapshot of a company’s available current assets.

“Net Working Capital” Takeaways 

So what is the legal definition of Net Working Capital?

Let’s look at a summary of our findings.

Net Working Capital Is Defined As:

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