NET WORKING CAPITAL: HOW IT IS CALCULATED AND EXAMPLE - DUDAS - 2025

The net working capital is the difference between current assets of a company such as cash, accounts receivable (unpaid bills by customers) and inventories of raw materials and finished products, and its current liabilities, such as accounts pay.

Net working capital is a measure of both a company's operating efficiency and its short-term financial health. If the current assets of a company do not exceed its current liabilities, then there may be problems paying creditors, or it may even go bankrupt.

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Most projects require an investment in working capital, which reduces cash flow, but cash will also be reduced if money is collected too slowly or if sales volumes begin to decline, causing a drop in accounts receivable.

Companies that use working capital inefficiently can increase cash flow by squeezing suppliers and customers.

What is it and what is it for?

Net working capital is used to measure the short-term liquidity of a business and also to get a general impression of the managerial ability of the business to use assets efficiently.

Net working capital can also be used to estimate the ability for rapid growth of the business.

If the business has significant cash reserves, it may have enough money to get the business high quickly. In contrast, a tight working capital situation makes it highly unlikely that a company will have the financial means to accelerate its growth rate.

A more specific indicator of growth capacity is when accounts receivable payment terms are shorter than accounts payable terms, meaning that a business can collect cash from its customers before it has to pay its customers. suppliers.

The net working capital figure is most informative when tracked on a trend line, as it can show the gradual improvement or decrease in the amount of net working capital over time.

Reliability

The amount of net working capital can be extremely misleading for the following reasons:

Credit line

A business may have a line of credit available, which could easily pay any short-term financing gap indicated in the net working capital calculation, so there is no real risk of bankruptcy. When an obligation must be paid, the credit line is used.

A more nuanced view is to review the net working capital with the remaining available balance of the credit line. If the line has almost been used up, there is greater potential for a liquidity problem.

Anomalies

If you start to measure from a certain date, the measurement could have an anomaly that is not indicated in the general trend of net working capital.

For example, there may be an old large one-time pay account that has not yet been paid, making the net working capital figure appear smaller.

Liquidity

Current assets are not necessarily very liquid. In this sense, they may not be available to pay short-term liabilities. In particular, inventory can only be immediately convertible to cash at a large discount.

Also, accounts receivable may not be collectible in the short term, especially if the credit terms are excessively long.

This is a particular problem when large clients have considerable bargaining power over the business. They may deliberately delay your payments.

How is it calculated?

To calculate net working capital, current assets and current liabilities are used in the following formula:

Net working capital = Current assets - Current liabilities. Thus:

Net Working Capital = Cash and Cash Equivalents + Negotiable Investments + Trade Accounts Receivable + Inventory - Trade Accounts Payable - Accrued Expenses.

The net working capital formula is used to determine the availability of a company's liquid assets by subtracting its current liabilities.

Current assets are assets that will be available within a period of no more than 12 months. Current liabilities are liabilities that mature within the 12-month period.

If the net working capital figure is substantially positive, it indicates that the short-term funds available from current assets are more than sufficient to pay current liabilities as payments are due.

If the figure is substantially negative, the business may not have sufficient funds available to pay its current obligations and may be in danger of bankruptcy.

Net working capital indicator

The working capital indicator (current assets / current liabilities) shows whether a company has enough short-term assets to cover its short-term debt.

A good working capital ratio is considered between 1.2 and 2.0. A ratio of less than 1.0 indicates negative net working capital, with possible liquidity problems.

On the other hand, a ratio of more than 2.0 may indicate that a company is not using its excess assets effectively to generate the maximum possible income.

A declining working capital ratio is a red flag for financial analysts.

You can also consider the quick relationship. This is an acid test of short-term liquidity. It only includes cash, marketable investments, and accounts receivable.

Example

Let's look at Paula's retail store as an example. She owns and operates a women's clothing store that has the following current assets and liabilities:

Cash: $ 10,000

Accounts receivable: $ 5,000

Inventory: $ 15,000

Accounts Payable: $ 7,500

Accrued expenses: $ 2,500

Other business debts: $ 5,000

Paula could use a calculator to calculate net working capital like this:

Net working capital = ($ 10,000 + $ 5,000 + $ 15,000) - ($ 7,500 + $ 2,500 + $ 5,000)

Net working capital = ($ 30,000) - ($ 15,000) = $ 15,000

Since Paula's current assets exceed her current liabilities, her net working capital is positive. This means that Paula can pay all of her current liabilities using only current assets.

In other words, your store is highly liquid and financially strong in the short term. You can use this additional liquidity to grow the business or expand into additional clothing niches.

References

1. Investopedia (2018). Working Capital. Taken from: investopedia.com.
2. Steven Bragg (2017). Net working capital. Accounting Tools. Taken from: accountingtools.com.
3. Finance Formulas (2018). Net Working Capital. Taken from: financeformulas.net.
4. My Accounting Course (2018). Net Working Capital. Taken from: myaccountingcourse.com.
5. Harold Averkamp (2018). What is net working capital? Accounting Coach. Taken from: accountingcoach.com.