Net Working Capital

Net Working Capital is the liquidity ratio that indicates the company’s ability to use the current assets to pay off the current liabilities. It is the difference between current assets and current liabilities. It is one of the indicators to measure the company’s financial health.

The creditor, bank, and other vendors always pay close attention to this ratio as it tells how well the company manage its resource and convert them to cash. Current assets are the assets that can be converted to cash in a short time. When the company has high current assets, it will be able to pay back the loan and interest on time. The creditors will have more confidence in providing the loan to the company.

The company can manage the net working capital by controlling its current assets and current liabilities. If they want to increase the working capital, they could increase the current assets or pay off the current liability. The other way around, they can decrease working capital by decreasing current assets or increasing current liability.

Hight working capital is not always goods, the company may have enough cash and other current assets to settle the short-term obligation. But if we look closely, the company has put a huge capital in current assets such as cash, inventory, accounts receivable, and so on. They have lost the opportunity in using this capital to invest and generate more revenue. Management can use the capital to expand the business operation and get more returns.

The company with low working capital seems not to have good financial health, at least from the public perspective. People may think that company is in a bad condition when they have low working capital, they may not have enough cash to settle the current liability. However, it may not all be the case, management may prepare cash for short-term liability which will be due shortly. They do not bump the current assets like a waste of company capital while they can use it to invest somewhere else.

Net Working Capital Formula

The formula is similar to the working capital ratio, we simply deduct the current liabilities from the current asset.

Net Working Capital = Current Assets – Current Liabilities

The current assets include:

Cash: it includes cash equivalent which can convert to cash immediately such as cheque, marketable security, and short-term government bond.
Inventory
Account Receivable: The balance that the company expects to collect from the customer within a year.
Prepayment: that can convert to cash within a year.

The current liabilities include:

Accounts Payable
Tax Payable
Unearned Revenue
Accrued Expense

Net Working Capital Example

For example, base on the Company financial statement, they have the following balance:

Cash: $ 5,000
Inventory: $ 20,000
Account Receivable: $ 15,000
Accounts Payable: $ 10,000
Accrued Expense: $ 5,000
Unearned Revenue: $ 4,000

Please calculate the net work capital of the company.

Net working capital = (5,000 + 20,000 + 15,000) – (10,000 + 5,000 + 4,000) = $ 21,000

Net Working Capital Analysis

Net working capital will show the difference between the current assets and current liabilities. Positive net working capital means that the current assets are bigger than current liabilities. It means the company can use the asset to generate cash to cover the liabilities.

If the net working capital is negative means that the current asset is less than current liabilities. The company cannot use the current asset to pay off the debt. If the creditor requires to pay the debt, the company may force to use long-term assets or net income to pay it off. However, it will impact company performance as we have to sell long-term assets which are mainly for company operation. It will lead to more serious problems for the company in the long term.

Advantage of Net Working Capital

The positive net working capital means that we have more assets to invest or use besides the current obligations.
It provides the best estimate of the company’s liquidity if they have enough cash to pay for the current obligation.
This net working capital enables us to compare with other company within the same industry in order to evaluate liquidity status.

Disadvantage of Net Working Capital

Not all current assets are easy to convert to cash. In this formula, we assume that all the current assets will be able to convert to cash to settle the current liability.
Positive Net working capital means a good sign for the company, however, it is not always the case. It may show that the company is not efficient to use the assets.
It is not easy to use net working capital to measure a company’s liquidity as some current liabilities will not require to pay immediately.

How to Increase Net Working Capital?

We can increase the net working capital by:

Increase Cash balance

The higher cash on hand, meaning we can use them if the creditor asks for immediate payment. However, to keep too much cash we may lose the opportunity to use them for other investments.

Increase Inventory

The company can increase the inventory in the warehouse which is ready to sell to the customers. However, keeping too much inventory will increase the storing cost for the company and it will face the risk of inventory being obsolete too.

Pay off accounts payable: We should pay off the accounts payable as soon as possible, however, doing so can reduce our cash balance and reduce the opportunity for investment.
Using long-term debt to pay off current liabilities: The company can reduce the current liabilities balance by financing the long-term debt. This method will decrease the current liabilities without impacting the asset balance.

Conclusion

Net working capital is an indicator to evaluate the company short-term financial health. However, it does not tell everything. We have to look at other factors before making any decision. Low net working capital only indicates the risk of missing short-term liability payments. While higher net working capital is a good sign in dealing with short-term debt. But it will not tell a whole story, we have to analyze many other factors before coming to a conclusion.