Role of Net Working Capital in Financial Management
- What is Net Working Capital?
- Why it Matters for Businesses
- Components of Net Working Capital
- Formula to Calculate Net Working Capital
- Importance of Calculating Net Working Capital
- Problems Arising from Insufficient Net Working Capital
- How to Improve Net Working Capital
- Difference Between Gross and Net Working Capital
- Net Working Capital in Financial Modelling and Forecasting
- Frequently Asked Questions (FAQs)
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.
Read More: Growing Your Business With Machinery Loan—It Is Easy!
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. Why it Matters for Businesses
It is crucial to remember that all assets and liabilities have specific timeframes. While assets are resources you can convert into cash within a single operating cycle (usually one year), liabilities are the debts you must pay during that same period. Monitoring these trends is also a key factor that credit bureaus like CIBIL/TransUnion analyse when assessing a business's creditworthiness and repayment capacity.
Components of Net Working Capital
To calculate net working capital, you must account for all business transactions that fall under current assets and current liabilities.
Current Assets
These are economic benefits you expect to receive or convert into cash within the next 12 months.
- Cash and Equivalents: Money on hand, foreign currency, and short-term liquid investments.
- Inventory: Raw materials, work-in-progress (WIP), and finished goods.
- Accounts Receivable: Payments due from items sold on credit, less provisions for doubtful debts.
- Marketable Securities: Short-term investments that can be quickly sold on the NSE/BSE.
- Notes Receivable: Claims to cash through signed contracts.
- Prepaid Expenses: Payments made in advance for services (like insurance) yet to be received.
- Other Current Assets: Items like short-term GST Input Tax Credit (ITC) assets.
Current Liabilities
These are debt obligations that a company owes and expects to pay back within a year.
- Accounts Payable: Money owed to suppliers for goods or services.
- Wages Payable: Accrued salaries for employees.
- Current Portion of Long-term Debt: Principal payments due on long-term loans within the next 12 months.
- Statutory Dues: Taxes like TDS, GST, or PF payable to the government.
- Unearned Revenue: Payments received for services not yet provided.
Formula to Calculate Net Working Capital
Calculating the NWC helps you understand how well you can cover your obligations.
Formula Presentation
The fundamental formula to calculate net working capital is:
Net Working Capital = Total Current Assets – Total Current Liabilities
Step-by-Step Calculation Example
Consider a company with the following balance sheet items:
- Current Assets: Inventories (40,000) + Accounts Receivables (50,000) + Debtors (5,000) + Cash (10,000) = 1,05,000.
- Current Liabilities: Short-term loans (30,000) + Income Tax (5,000) + Creditors (10,000) = 45,000.
NWC Calculation:
1,05,000 (Current Assets) - 45,000 (Current Liabilities) = 60,000
The company has a net working capital of Rs. 60,000 available for its short-term obligations.
Types of Net Working Capital
The classification of working capital depends on the perspective a company adopts.
Balance Sheet Approach
- Net Working Capital (NWC): The difference between current assets and current liabilities.
- Gross Working Capital: The total sum of all current assets held by the company without deducting liabilities.
Operating Cycle Approach
- Permanent Working Capital: The minimum level of current assets required to conduct business operations continuously throughout the year.
- Temporary Working Capital: Additional assets needed to meet seasonal demands or peak periods, often financed via short-term loans.
Importance of Calculating Net Working Capital
Business Liquidity
The primary objective of calculating NWC is to assess business liquidity—the ability to meet short-term obligations as they fall due.
Creditworthiness
A positive NWC indicates that a company holds sufficient assets to meet liabilities, which is a sign of financial stability to lenders. In the Indian banking context, following the Tandon Committee recommendations, many lenders consider a Current Ratio of 1.33:1 as a standard for working capital assessments.
Cash Flow Management
Net working capital is instrumental in maintaining a company’s cash flow. For instance, if a company is too slow in retrieving pending money from customers (high DSO), its cash flow may see a dip.
Financial Health Indicator
NWC reflects operational efficiency. A larger NWC suggests a higher likelihood that the company can finance its short-term debt and day-to-day requirements like raw material purchases.
Problems Arising from Insufficient Net Working Capital
A shortage of net working capital can lead to severe financial and operational risks:
- Operational Disruptions: Inability to purchase raw materials or pay employee wages on time.
- Loss of Credibility: Failing to pay suppliers can damage business relationships and adversely impact your commercial credit score.
- Missed Opportunities: Lack of funds prevents a business from scaling or investing in equipment upgrades.
- Risk of Insolvency: Prolonged negative net working capital conditions may lead to bankruptcy if the business cannot generate cash quickly enough.
Also Read: Guide to Understanding Working Capital Loans
How to Improve Net Working Capital
Small businesses can implement several strategies to optimize their net working capital:
- Inventory Management: Implement Just-in-Time (JIT) or age-analysis to reduce capital tied up in slow-moving or obsolete stock.
- Debtor Management: Offer early payment discounts to customers to reduce the Days Sales Outstanding (DSO).
- Creditor Management: Negotiate longer payment periods or better credit terms with vendors to align with your cash inflow cycle.
- Asset Utilization: Return unused products to vendors to receive refunds and free up cash.
- Financing Options: If your business experiences a temporary gap, you can bridge it with net working capital finance from a regulated NBFC like Hero FinCorp to meet operational needs without stressing long-term finances.
Difference Between Gross and Net Working Capital
| Feature | Gross Working Capital | Net Working Capital |
|---|---|---|
| Definition | Total amount of current assets. | Current Assets minus Current Liabilities. |
| Focus | Overall liquidity available for operations. | Precise measure of actual available capital after settling debts. |
| Indication | Total resources at the company's disposal. | Short-term financial health and solvency. |
Net Working Capital in Financial Modelling and Forecasting
NWC plays a crucial role in financial modelling as it directly impacts cash flow projections.
- Valuation: Projections are used to estimate Free Cash Flow to the Firm (FCFF), which is critical for assessing a company's total value.
- Operational Efficiency: Analysts examine historical net working capital data to identify trends in how well a company manages its working capital cycle.
- Strategic Planning: Accurate NWC forecasting is essential for planning business expansions, mergers, or acquisitions.
Also Read: Working Capital Policies
Frequently Asked Questions (FAQs)
What is net working capital?
Net working capital is the difference between a company's current assets (like cash and inventory) and its current liabilities (like accounts payable and short-term debt). It reflects a company's operational liquidity.
How to calculate net working capital?
You can calculate net working capital using the formula: Current Assets - Current Liabilities. This is typically derived from the company's latest balance sheet.
Why is net working capital crucial for businesses?
It ensures the business remains solvent and can pay its daily operational expenses, suppliers, and employees on time, thereby avoiding operational halts.
What causes negative net working capital?
It occurs when a company's current liabilities exceed its current assets, often due to excessive short-term borrowing, slow-moving inventory, or a high volume of uncollected receivables.
How can businesses improve their net working capital?
Businesses can improve NWC by optimizing inventory, collecting receivables faster, negotiating better vendor terms, and utilizing net working capital finance from regulated NBFCs for bridge funding.
What are the components of net working capital?
The components include current assets (cash, inventory, accounts receivable, prepaid expenses) and current liabilities (accounts payable, short-term debt, statutory dues, and wages).
RBI Compliant Disclaimer
Investment in financial products and credit facilities involves inherent risks. The information provided in this blog is for educational purposes only and does not constitute formal financial, legal, or tax advice. Net working capital requirements vary significantly based on industry, business model, and operating cycles. Lending is at the sole discretion of the financial institution and is subject to credit appraisal and RBI norms. Hero FinCorp is a regulated Non-Banking Financial Company (NBFC) registered with the Reserve Bank of India (RBI). Please read all scheme-related documents, terms and conditions, and interest rate disclosures on our official website before applying.
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Disbursement
The act of paying out money for any kind of transaction is known as disbursement. From a lending perspective this usual implies the transfer of the loan amount to the borrower. It may cover paying to operate a business, dividend payments, cash outflow etc. So if disbursements are more than revenues, then cash flow of an entity is negative, and may indicate possible insolvency.