Role of Net Working Capital in Financial Management

Business owners must invest money into their business to generate revenue. However, spending too much money may cause them to see red. That’s when the net working capital (NWC) comes in. It is the difference between a company’s current assets and liabilities. When the NWC is green, it means that the business is generating enough revenue to fulfil its current working capital needs. Businesses use various tools and techniques to calculate the NWC, estimate their company's liquidity, and understand their overall financial health. In the following sections, you will get to learn the definitions and formulas to calculate net working capital.

What is Net Working Capital?

The NWC, or net working capital, measures your firm’s short-term financial health by calculating the difference between your current assets and liabilities. The remaining amount is the working capital you can use in the immediate future. It is crucial to remember that all assets and liabilities have timeframes. While assets are immediately available resources you can convert into cash within a year, liabilities are the debts you must pay during that period.

Since the figures frequently change during a year, you must track NWC periodically and graph it to show current trends. However, some companies use it occasionally to get a quick idea of their financial health.

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Who Needs to Calculate the Net Working Capital?

As a small business owner, you must calculate NWC to better understand the firm's short-term financial well-being. Finance teams and accountants at large corporations and companies also use it to create client financial statements. It is also useful for lenders and investors who want to see how the company owners handle their short-term liabilities. Based on this information, they can make informed lending and investing decisions.

What Does the Net Working Capital Include?

The net working capital indicates your company’s financial health. It shows liquidity by subtracting a company’s liabilities from its assets. That is why it is important to understand the difference between gross working capital and net working capital. The NWC calculation method includes the following items present in the balance sheet.

Current Assets: These are economic benefits you expect to receive in the next 12 months. You have the right to receive these benefits, and if the need arises, you can liquidate them to convert them into cash. Current assets you can use to calculate NWC include the following.
 

• Cash and Equivalents

  It is the money you have on hand, including foreign currency, investments, and money market accounts with low risk and smaller investment terms.

• Inventory

  It includes unsold goods lying in your stores. That includes raw materials, purchased items for manufacturing, partially assembled products, and finished goods ready for sale.

• Accounts Receivable

  It includes all payments from all items sold on credit, comprising doubtful payments.

• Notes Receivable

  It includes all claims to cash for other agreements, often through physically signed contracts.

• Prepaid Expenses

  These include the value of all expenses you made in advance. Although it is challenging to liquidate them when you need cash, they still carry value and include in current assets.

• Others

  These include all short-term assets, like tax assets that reduce future liability.

Current Liabilities

These include short-term debts your company has to pay within a year, including accounts payable, wages payable, the present component of long-term debt, obligations to government bodies, dividends payable, unearned revenue, etc.

 

Formula to Calculate Net Working Capital

Calculating the NWC helps you understand how well you can cover your obligations in the short term. Follow these steps to calculate net working capital:

1. Add Up the Current Assets

   Start by adding all the current items in the assets line, including cash, cash equivalents, accounts receivable, and marketable investments.

2. Add Up the Current Liabilities

   Next, add up all liabilities in the balance sheet, including payrolls, accounts payable, interest payable, and sales tax payable.

3. Calculate the NWC

   Subtract all current liabilities from the assets. The figure you receive is the business’s NWC.

The formula to calculate net working capital is:
Net Working Capital = Current Assets – Current Liabilities

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Importance of Calculating Net Working Capital

Calculating the net working capital is significant to get an idea of your business liquidity and whether you have enough money to cover your short-term obligations. An NWC of zero or greater indicates that you can cover your current obligations efficiently. Generally, the higher the NWC, the better prepared it means to cover short-term obligations. Every business should, at all times, have enough capital to cover its bills for a year.

NWC is extremely helpful in comparing how figures change over time, allowing you to identify the trend of business liquidity and see how it improves or declines. In case of a significantly positive NWC, it is a good sign that you can meet obligations in the future. However, a negative NWC suggests you need additional net working capital finance for your upcoming payments. Calculating the figure also indicates how quickly your company can grow. For instance, substantial capital reserves show you can scale your business operations rapidly by investing in equipment upgrades.

Tips to Improve Net Working Capital

As a small business owner, you can make certain changes to your operations to improve your NWC. Some of those adjustments include the following.

• Modify your payment terms to cut down the billing cycle and ensure that your customers pay more frequently for the goods or services they avail.
• Follow up with the clients diligently as soon as they have a due invoice. It helps in the collection of late payments more quickly.
• Return unused products to the vendors to receive a refund of the cost invested.
• Opt for a longer payment period for vendors to minimise late fee penalties.

As a business owner, you are in charge of your net working capital management. Understanding how to calculate it is just the first step to take. Use the best calculation methods to manage the financial data and advance towards financial success. If needed, borrow net working capital finance from a reliable partner like Hero FinCorp and meet your working capital needs without stressing your finances.