Net working capital (NWC) is a financial metric that measures a company's liquidity and ability to meet its short-term financial obligations. In simple terms, net working capital shows the difference between a company's current assets and current liabilities. It gives a snapshot of the financial health of a business at any given point in time.
Understanding and properly managing net working capital is crucial for companies of all sizes. It directly impacts day-to-day operations, investment decisions, and access to financing. That's why net working capital tends to be closely watched by management, investors, creditors, and analysts.
In this comprehensive guide, we will walk through how to calculate net working capital, interpret the results, use it in financial modeling and analysis, and provide tips for improving it.
The formula for net working capital is:
Net Working Capital = Current Assets - Current Liabilities
By subtracting current liabilities from current assets, you get a measure of the short term operating liquidity available to the business after meeting its near term obligations.
Here is the net working capital calculation for a fictional Company XYZ based on its balance sheet:
Net Working Capital = Current Assets – Current Liabilities
= $35 million - $19 million
= $16 million
So Company XYZ has a net working capital of $16 million. This means it has $16 million of liquid assets available after paying off all near term liabilities.
The interpretation of net working capital depends on the context and industry in which the company operates.
As a rule of thumb, a positive and high net working capital is preferred because it demonstrates the company's ability to fund operations and invest for growth. However, an excessively high net working capital could mean inefficiencies in putting capital and assets to work in the business.
A negative net working capital means liabilities exceed assets and indicates a higher risk of insolvency. However, some growth companies or those with seasonal business may strategically operate with negative working capital by using sources like credit lines.
The key is to assess the trends in the metric over quarters and years instead of merely the latest value. Sustained decreases in net working capital could foreshadow cash flow troubles for the company.
In financial models, changes in net working capital from one period to another directly impact cash flows.
For example, if accounts receivable increases from one year to the next, it represents a use of cash. Essentially some cash was invested towards higher sales in the future. On the other hand, if accounts payable increases from one year to the next, it represents a source of cash, as you are temporarily holding on to some payments owed.
Understanding this interplay between income statement, balance sheet, and cash flow statement through net working capital is very important for properly structuring financial models. The values for items like accounts receivable, inventory, accounts payable etc must align logically across the three statements.
For the purpose of valuation, analysts focus on free cash flows, which represent the actual cash available for distribution after accounting for increases or decreases in net working capital.
Here are some ways companies can optimize their net working capital:
Tracking and managing net working capital is an indispensable practice for healthy corporate finance and governance. With the knowledge from this guide, you now have the tools to start monitoring and improving your company's working capital.