Working capital is also referred to as the net working capital as possessed by a business, and it represents the difference between the short-term assets and the current liabilities. It is a liquidity ratio, and it assesses the business’s ability to meet short-term needs and fund projects. It will be ideal if the current assets are significantly more than the short term expenses because the goal is to have a positive net working capital balance. There are different means of computing the net working capital that does not include money and debt but entail inventory, accounts payable, and accounts receivable.
Net working capital is calculated as follows:
New Working Capital = Current Assets – Current Liabilities
Another method would be:
New Working Capital = Accounts Receivable + Inventory – Accounts Payable
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Or, current assets (minus cash) – current liabilities (minus debt)
How Net Working Capital Works
The net working capital available may be used to evaluate if the business can develop rapidly. If there are substantial money reserves, then it can proliferate. On the other hand, if there are no stocks, it is not likely the company will have the resources for past paced development. Vendors, creditors, and management assess the company’s net working capital as it gives a snap of the short-term liquidities of the business and its ability to pay off liabilities with what is available.
Why It is Important
The Net Working Capital is significant as it describes the short term business resources. It is also one of the indicators that show the business efficiency and financial health. A positive net working capital would mean the business has the liquidity to pay for the expenditure and maintain utilities and invest in the future. Net working capital of zero means the firm can only meet the current obligations from recurring bills. If the ratio is zero, it means it cannot keep up with the day-to-day operational requirements.
Increasing the Net Working Capital
Should the business have issues with meeting financial needs, some strategies can help to free revenue to improve the ratio.
- Selling of long term assets- If the business has properties and equipment, executives may consider disposing unused properties. They may also sublease space in the buildings. The goal is to increase the revenue coming in, thereby improving the levels of current assets. It also means the net working capital will increase.
- Refinancing the short term debt: short term debt means loans that are due to be paid back in a year or less. These debts would fall under the group of current liabilities. The refinancing of short-term loans with long-term debt may allow for stretching the payment schedules and reduce how much is due monthly. Long term loans are under the balance sheet long term debts section, so they would not be calculated as part of the working capital.
- Improving the rate of inventory turnover – slow moving inventory means the business will not have significant working capital. The idea is to revamp the restocking procedures, so the inventory gets to the customers faster. Fast selling inventory should be the goal, and the business should not take on more orders than necessary.
Advantages of Net Working Capital
A high net working capital would mean the company can meet its current financial goals. It is also possible to invest in other operational needs if the business has a good net working capital ratio.
Disadvantages of the Net Working Capital Ratio
Should the business become too limited while attempting to increase the net working capital, it may sacrifice its stability over the long term. The expenses may overrun the regular operations and lead the business to insolvency. For example, refinancing the short-term obligations to become long-term loans will increase the NWC ratio. On the other hand, the long term debts on paper are at a higher level compared to the short term loans. Refinancing of the majority of the debt may lead to increased debt costs over the long term. Potentially that would place the company on uneven footing. From the analyst’s perspective, it would be essential to set a balance by using the net working capital alongside other ratios that consider the long term debts of a company.
The Net Working capital can also not tell the situation during recessions when the inventory and cash reserves may be up. The people are not purchasing products, and the company is saving up because of the future’s unpredictability. A high ratio can be misconstrued as a positive financial sign when, in fact, it is not reading the market situation.