Commonly abbreviated as NWC, net working capital is a metric that measures the company’s liquidity and operational efficiency. Mathematically, the ratio defines the differences between a company’s current assets and liabilities. In other words, net working capital offers a straightforward way to calculate a company’s current liquidity.
Why Measuring Net Working Capital is Important to Investors
A company can have zero, positive, or negative net working capital. A company with a positive NWC has the resources to meet its business expenses and can afford to fund other operations. With a positive NWC, the company has reserve funds for emergencies, business expansion, and new investments. Many companies prefer a net working capital above zero because inventory and accounts receivable transactions are unpredictable within a year in most industries.
A company cannot afford to fund essential and non-essential activities if its net working capital is negative. Instead, the company should find other income streams to meet its obligation and avoid bankruptcy. With a net-zero NWC, a company has enough current liquidity to fulfill its obligations, but no funds for unrelated expenses.
Also, investors may already be using the current ratio, also known as the working capital ratio, which measures a company’s liquidity and efficiency to pay off short-term liabilities with current assets. It’s directly related to net working capital.
How to Calculate Net Working Capital
The formula for calculating net working capital can vary from one sector to another, depending on the variables in a company’s business.
However, the general way to calculate NWC is by subtracting current liabilities from current assets (such as inventory, marketable securities, and prepaid expenses).
Performing this calculation can help investors understand whether a company can cover its short-term obligations (within the next 12 months):
The steps below are used to calculate a company’s net working capital:
- Sum up all the current assets
Take a look at the company’s financial reports, particularly the balance sheet. Find the current assets section. It includes assets such as marketable securities, account receivables (AR), cash and cash equivalents, marketable investments, completed inventory, raw supplies.
- Sum up current liabilities
Now find the current liabilities. The balance sheet will liabilities such as sales tax payable and accounts payables. Add all the items in this line.
- Calculate the business’s net working capital
Deduct the sum in step 2 (Current liabilities) from the sum in step 1 (Current assets). The final figure is the company’s NWC.
NWC Formula
The formulas for calculating net working capital are straightforward. The metric can be calculated using one of the three following formulas:
- Net Working Capital = Current Assets (excluding all the cash in the company) – Current Liabilities (less all the debt in the company)
- Net Working Capital = Current Assets – Current Liabilities
- NWC = Accounts Receivable + Inventory (less Accounts Payable).
Each of these elements is described below:
Current Assets
Current assets include the following variable that the company expects to sell or consume within one financial year:
- Cash and cash equivalents: Include all the cash available in the company. Add all low-risk money market accounts and foreign currency in the company’s low-investment duration accounts
- Checking and savings accounts: include any money that can impact the company’s liquidity
- Stocks and bonds, and other short-term investments that can increase the company’s liquidity within a year
- Accounts receivable: Any money that the company expects to receive for the goods and services delivered on credit
- Inventory: Any inventory that the company can liquidate within a year. It includes finished goods, raw materials in the company, unsold goods, and partially assembled inventories
- Prepaid expenses: The company can liquidate any accrued expenses such as rent, insurance premiums paid in advance
- Notes receivable: These include all promissory notes for any amount payable within a year. Check the financial statements for physically signed agreements accompanying these notes receivables.
Current Liabilities
These typically consist of the following liabilities due within the one financial year:
- Accounts payable: it consists of all unpaid purchases. The accounts payables allow businesses to use credit to purchase essential supplies such as raw materials. Accounts payable can also include credit extended by outside third parties to enable the company to meet obligations such as paying rent, operating utilities, and property tax.
- Accrued tax payable: These liabilities include all the accrued obligations to government bodies. Most short-term accrued taxes due within a year include accruals on the company’s tax obligations.
- A portion of the company’s long-term debt: If the business has a long-term debt, you can include the portion due the next one year in the current liabilities. All the expenses associated with this loan are current liabilities due in the next 12 months. For example, if a company has a 12-year debt, payment on the next 12 months is short-term debt, while the remaining 11 years is a long-term debt obligation.
- Dividend payable: The company’s financial statements contain essential information on all authorized payments, such as dividends to the shareholders. The company must pay the already authorized dividend payments. The dividends payable within the next 12 months are considered a current liability to the company. However, the company can decline future dividend payments after one year.
- Unearned revenue: The company may receive money for different projects in advance. However, if the company fails to deliver or complete the project as stipulated, it is recommended to return all capital received to the financing client. The capital received in advance becomes a current liability due within the normal operating cycle in the financial statements.
- Salaries and wages payable: Payroll liabilities are short-term obligations payable within the next 12 months.
Real-World Example of Finding Net Working Capital
The following real-world example features a consolidated balance sheet from Microsoft’s 2021 annual report. The balance sheet shows that Microsoft had cash and cash equivalents of $14,224, short-term investments of $116,110, $13,393 of other current assets, account receivables of $38,043, and $2,636 of inventory.
The company owed $15,163 for accounts payable, a current portion of long-term debt of $80,72, $10,057 of accrued compensation, unearned revenue of $41,525, short-term income taxes of $2,174, and $11,666 for other current liabilities.
Follow this step-by-step procedure to calculate Microsoft’s NWC.
Step 1: Sum up the Current Assets
Total current assets = (cash and cash equivalents) + (prepaid expenses) + (accounts receivable) + (investments) + (inventory) + (other short-term assets).
Microsoft’s total current asset = $14,224+ $116,110+ $38,043+ $2,636+ $13393
The total for current assets is $184,406.
Step 2: Sum Up the Current Liabilities
Total Current Liabilities = (accounts payable) + (Accrued tax payable) + (Salary and wages payable) + (Current long-term debt portion) + (Dividend payable) + (Unearned revenue).
Microsoft’s total current asset = $15,163+ $8,072+ $2,174+ $11,666+ $10,057+ $41,525
The total for current liabilities is $88657
Step 3: Calculate Net Working Capital
Net working capital = Total current assets less total current liabilities.
NWC= $184,406-$88,657
Net working capital for Microsoft is $95,749.
Step 4: Interpretation of the results
Based on the above real-life example, the net working capital for Microsoft is $93,798, which is a positive value. The result indicates that the company was able to meet its financial obligation for the financial year. The NWC value that Microsoft had sufficient liquidity to venture into expansions, upgrades, and other investments.
Most companies with a significant positive net working capital have essential short-term security to avoid bankruptcy. However, a challenge arises when such companies have too much liquidity. Such a scenario indicates that the company has an undesirable inventory accumulation. As a result, it is advisable to use some of the accumulated liquidity in investments that will earn better returns.
Negative Net Working Capital
It is also possible for a company to have a negative NWC. However, a negative net working capital indicates a company’s poor financial health. A negative NWC result could indicate many things. For instance, it shows a possible good relationship between the company and its lenders. While including such information in the financial statements is essential, the company may have favorable loan repayment terms unknown to the financial analyst. For instance, the company may repay its short-term loans faster than the standard period in the balance sheet. Besides, the company is likely benefiting from a longer loan repayment period. Such a scenario may affect the NWC value.
Many scenarios can result in a negative NWC even when the company is not in poor financial health. For instance, if a company recently invested in a capital-intensive project. Such a company may pose a negative NWC value despite thriving.
Additionally, seasonal companies sometimes rely on financing while waiting for a successful season.
What Are the Limitations of Using Net Working Capital?
After calculating net working capital, a key issue arises regarding relying on NWC as the only financial health indicator. Ultimately, various limitations make it a misleading metric.
NWC is Agnostic to Cash Flow
One of the major concerns with the net working capital formula is that it does not consider operating cash flow. Therefore, the NWC value may mislead investors unaware of the company’s operating cash flow. For instance, a business with a large line of credit may have a negative NWC, although the line of credit is an asset.
Net Working Capital Does Not Account for Changing Assets and Liabilities
A fully operating business is subject to changes in assets and liabilities throughout the financial year. NWC considers total liabilities and assets without considering the changes that occur before and after a financial analyst collects financial information. Therefore, the net working capital value may not accurately indicate the business’s financial health because the company’s working capital position changes.
NWC Fails to Include Underlying Accounts
Standard deviation is an important data function in finding and accurate data analysis. In the case of net working capital, the formula emphasizes account receivable while ignoring other accounts. For most companies, it is possible to receive large accounts receivable payments in a year; for others, all their current assets may be in the accounts receivable. Such businesses may have a positive working capital despite a negative NWC value.
NWC Is Not Applicable for Companies That Do Not Follow the Standard Accounting Practices
Businesses in a fast-paced environment may fail to adhere to international accounting standards and practices, especially debt obligation. Net working capital uses the best practices of accounting, which can be misleading for a company with separate debt agreements. Besides, NWC does not consider errors such as incorrectly processed invoices or the missed agreement scope.
Net Working Capital Formula Ignores External Forces
External threat can impact the business’s net working capital. Inventory theft and the inability to move stock can impact inventory turnover. It can drain the cash flow or bankrupt the accounts receivable. Unfortunately, NWC does not consider external forces when determining the company’s operational efficiency. Therefore, the NWC value can mislead investors in this situation.
Evaluating Startups for Venture Capital
The NWC calculation is an important metric for anyone investing in venture capital. It can impact how venture capitalists make financing decisions. Over the years, venture capital has been a major financing source for companies like Microsoft and Amazon. However, venture capitalists are more interested in startups, where venture capital is the primary funding source.
Therefore, venture capitalists use different measures to evaluate the business’s business model, the team, the market opportunity, and their product. Net working capital helps venture capitalists evaluate if a startup has a sustainable business model to generate revenue or profit. Venture capitalists are highly likely to invest in a startup with the potential to generate significant revenue and remain profitable in the future.
Besides, startups can use this calculation to determine if the business is worth accruing debt. Using NWC gives them an accurate picture of the startup’s financial health. The latter is possible because net working capital value includes all the current assets in the balance sheet and liabilities while accounting for the startup’s overall profitability.
How Can Investors Use Net Working Capital for Investing?
Net working capital is an essential metric for reviewing the company budget sheet. Investors should understand this metric to know when it is a practical investment tool. NWC reflects the company’s operational efficiency and resource management in the day-to-day business activities.
Investors can use NWC to determine if a company has the resources to remain solvent and profitable. For instance, a company with too little NWC cannot pay off its outstanding liabilities or generate profits for its investors.
Either way, experts agree diversification can be key to the long-term growth of an investment portfolio.
Alternative Investments and Portfolio Diversification
Traditional portfolio asset allocation envisages a 60% public stock and 40% fixed income allocation. However, a more balanced 60/20/20 or 50/30/20 split, incorporating alternative assets, may make a portfolio less sensitive to public market short-term swings.
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In some cases, this risk can be greater than that of traditional investments.
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All securities involve risk and may result in significant losses. Alternative investments involve specific risks that may be greater than those associated with traditional investments; are not suitable for all clients; and intended for experienced and sophisticated investors who meet specific suitability requirements and are willing to bear the high economic risks of the investment. Investments of this type may engage in speculative investment practices; carry additional risk of loss, including possibility of partial or total loss of invested capital, due to the nature and volatility of the underlying investments; and are generally considered to be illiquid due to restrictive repurchase procedures. These investments may also involve different regulatory and reporting requirements, complex tax structures, and delays in distributing important tax information.
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