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.
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.
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:
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.
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.
Deduct the sum in step 2 (Current liabilities) from the sum in step 1 (Current assets). The final figure is the company’s NWC.
The formulas for calculating net working capital are straightforward. The metric can be calculated using one of the three following formulas:
Each of these elements is described below:
Current assets include the following variable that the company expects to sell or consume within one financial year:
These typically consist of the following liabilities due within the one financial year:
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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