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Net Working Capital (NWC)

Net working capital looks at the portion of a company’s assets and liabilities that are used in its day-to-day operations. Net working capital is defined as the difference between a company's current assets and its current liabilities. These are also known as the working capital accounts.

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What is net working capital?

Net working capital looks at the portion of a company’s assets and liabilities that are used in its day-to-day operations.

Net working capital is defined as the difference between a company's current assets and its current liabilities. These are also known as the working capital accounts.

The net working capital formula is:



Net working capital can be a positive or negative number.

Positive net working capital means the company has more money coming in than going out. Net working capital means the company has more short-term debt than short-term liabilities. This is not necessarily bad, as it means company is funding its growth by borrowing from its suppliers (and putting off paying them).

Summary
  • Net working capital = Current assets - Current liabilities
  • Net working capital can be positive or negative.
  • Positive net working capital means a company is more than able to pay its bills.

How should you think about net working capital?

The idea to keep in mind is the recurring transition of inventory to accounts receivables to cash on the asset side, and on the liabilities side, the recurring conversion of supplies to accounts payable to cash outlay.

The conversion from inventory to accounts receivable to cash is a source of funds that company uses to pay its liabilities.

Example

Let’s look at a company that makes bags to illustrate the transition of inventory to accounts receivable to cash, and the transition of supplies to accounts payable to cash outlay.

CURRENT ASSET

Current Asset Example
Inventory Bags that the company is ready to sell
Accounts receivable Bags sold to a department store, but the company has not been paid yet
Cash The department store has paid the company
CURRENT LIABILITY
Current Liability Example
Supplies or COGS Fabric purchased by the company to make the bags
Accounts payable Company has not paid the fabric supplier yet
Cash outlay Company pays the fabric supplier

What does net working capital measure?

The amount of net working capital is an indication of whether a company can withstand a sales downturn. It’s a measure of a company’s financial strength.

What is a good net working capital number?

A positive net working capital is better than a negative one. Positive net working capital means the company has enough current assets to pay off its current liabilities. Negative net working capital means the company does not have enough to pay off its current liabilities.

Higher net working capital is better…

Why does a company need more current assets than current liabilities? Put another way, is it okay if a company’s current assets is equal to its current liabilities?

The reason company’s generally want more current assets than current liabilities is because cash inflows are difficult to predict. The more predictable the conversion of current liabilities to cash is, then less net working capital a company needs.

Most company’s want some margin or buffer to make sure that it can pay off its current liabilities. The higher the net working capital, the greater the company’s ability to pay its bills.

…Too high net working capital is not good

If a company’s net working capital is too high, this is not a good either. This could indicate the company is holding too much inventory or it’s not investing its excess cash.

What are current assets and current liabilities?

Current assets generally turn into cash over the operating period of the company. Current liabilities are accounts that will be due for payment over the operating period.

Example

Let’s say we are a sandwich shop. We make money in two ways. First, we sell sandwiches to customers who come to our shop for lunch. Second, we sell pre-made sandwiches to the supermarket down the street.

Current assets: The supermarket pays us 30 days after we deliver our pre-made sandwiches. This would be considered a current asset, since we expect to receive payment or cash during the current operating period.

Current liabilities: Unfortunately we don’t make the breads for our sandwiches in-house. We buy them from a bakery in town. They deliver bread every morning, and we pay them on Fridays. This would be a current liability because we will need to pay them during the current operating period.

Current assets

Current assets include:

  • Cash
  • Inventory
  • Accounts Receivable
  • Property

Current liabilities

Current liabilities include:

  • Wages
  • Rent
  • Utilities
  • Taxes
  • Short-term debt that is due within a year

How to calculate net working capital

The net working capital formula is:



Variations in calculating net working capital

Net working capital is always calculated using current asset and current liabilities, but there is some discretion in determining what counts as a current asset and what counts as a current liability.

Including or excluding cash in current assets

For example, cash is often included in current assets. However, you may want to exclude cash if you are looking at a newly formed company and the cash on the company's balance sheet is primarily from the formation capital that was invested into the business.

In a more established company, cash would be included as part of current assets.