Net working capital (NWC) and changes in NWC throughout the years play crucial roles for businesses. Positive or negative changes in the net working capital indicate the difference between the NWC of any two periods (months, quarters, current and previous years).
Accountants should track changes since they provide business management with valuable insight. Let us take a closer look at NWC and how to calculate changes.
What Is Net Working Capital?
A net working capital (or NWC) is the difference between the business’s current assets, such as cash, accounts receivables, inventories, etc., and its current liabilities, such as accounts payable, debts, etc.
The net working capital measures a business’s liquidity, its short-term financial health, and operational efficiency. If the company has a positive net working capital, it can invest it to improve the business.
But if a business’s liabilities exceed the current assets, then it’s a possible sign of difficulties to pay back creditors. The company may even go bankrupt if the current assets don’t exceed liabilities.
What Is Net Working Capital (NWC)?
In accounting, the “Change in NWC” section of the cash flow statement tracks the net change in operating assets and liabilities during a specific period. Typically, two periods are compared — previous and current years.
A business owner needs total current assets and total current liabilities for the current and previous years to calculate the change in NWC. The higher the total number of current assets or the lower the total current liabilities, the higher NWC.
An increase or decrease of NWC isn’t always bad or good. In some cases, the decrease may be caused by increased liabilities since the company acquired a debt to optimize business processes. Eventually, it will bring positive effects, but only if the company keeps track of changes.
An increase in NWC may be bad if the company doesn’t have cash even though current assets increased while liabilities decreased. The change may reduce the company’s liquidity, or the company isn’t making any investments in business optimization.
That’s why business owners should keep track of changes in NWC to understand their situation. If a company asked for a credit to invest in business processes, but there are no positive changes next year, it could be a problem. But detecting the problem gives business owners a chance to rearrange a business plan and introduce improvements.
Change in Net Working Capital Formula
The formula to calculate the change in the net working capital is as follows:
Net working capital for the current period – net working capital for the previous period = change in net working capital.
To calculate the change, you need to determine the net working capital for both the current and previous period, and here’s the formula:
Current assets – current liabilities = net working capital.
In this article, you will find a comprehensive guide on calculating the change in NWC, current assets, liabilities, etc.
How To Calculate Change in Net Working Capital?
Make the process of calculating the change in NWC simpler by breaking the process into four phases as in the example:
- Calculate total current assets (for current and previous years).
- Calculate total current liabilities (for current and previous years).
- Calculate working capital (for current and previous years).
- Calculate the change in NWC.
Now let’s dive into the details!
Calculate Total Current Assets
The first important step is to determine the current assets of the current year and previous year (2021 and 2022). A current asset is a property that a business can easily convert into cash within one year. Here are some examples of current assets:
- cash equivalents;
- stock inventory;
- marketable securities;
- accounts receivable;
- pre-paid liabilities;
- other liquid assets.
Determine all company’s current assets and add them up to get a total. Let’s assume the company has $805,000 and $890,000 in current assets (2021 and 2022, respectively).
Calculate Total Current Liabilities
The next step is determining total liabilities (current and previous years). Here are some of the examples of current liabilities:
- accounts payable;
- interest payable;
- payroll taxes payable;
- short-term borrowings;
- current maturity of long-term debts;
- bank account overdrafts;
- dividends declared;
- accrued expenses;
- customer deposits;
- operating lease obligations due in one year;
- finance lease obligations due in one year;
- income taxes payable.
Determine what current liabilities a company has and add them to get a total amount. Let’s say the business has $700,000 and $650,000 in current assets (2021 and 2022, respectively).
Calculate Working Capital
The working capital formula is as follows:
Current assets – current liabilities = working capital
Now that you know both numbers for 2021 and 2022, it’s easy to determine the working capital.
Calculate The Change In NWC
The last step is to determine the change in working capital by using the formula. Subtract the previous year’s working capital from the current year’s working capital according to the calculations made above in the table.
$240,000 (2022) – $105,000 (2021) = $135,000.
So, the change in NWC is $135,000.
Explanation of Increasing And Decreasing Change in NWC
If a business’s change in net working capital increases year-over-year, there are two possible explanations. The company’s operating assets have increased, or their liabilities have declined during the year. It’s also possible that these situations occur at the same time.
If the balance increases because of the increase of current operating assets, then the situation represents an outflow of cash. If there is an increase in an operating liability, then the situation reflects an inflow of cash and vice versa.
Let’s assume the business’s accounts receivables (A/R) balance increased year-over-year, but its accounts payable (A/P) balance has also increased during the same period.
What net effect does this situation have for the business? More customers used credit as a form of payment, not cash. The absence of cash reduces the company’s liquidity.
The increase in the A/P balance occurred because of the delayed payments to the suppliers — the most common situation. Even though the payments will be eventually issued, the cash is still in possession of the company on paper. As a result, it increases the company’s liquidity.
So, the positive change in NWC reflects reduced cash flow, while the negative change implies the opposite and an increase in cash flow which is good for the company.
Let’s take the example from the previous section of the article. The company has a positive change in net working capital. One would assume it’s a good sign since the company has fewer liabilities and more current assets. Even though a lowered number of liabilities is a good sign, the company might have a problem with cash flow which reduces its liquidity.
On the other hand, if the company transforms its account receivable to cash and invests in the company’s growth, the positive change is a good sign. So, high NWC isn’t necessarily a bad or good thing for the company, and it depends on each individual situation.
Accountants can consider taking courses (free or paid) to offer valuable data to their employers. As mentioned, negative and positive changes in NWC can be interpreted differently, and it’s critical to understand how to read these changes.
Author: Charles Lutwidge