July 09, 2021

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Net Working Capital: Meaning, Measurement, and Optimization

Net Working Capital: Meaning, Measurement, and Optimization

In the course of their activities, many companies attract borrowed funds to finance current projects and expand the scope of their activity in the industry. However, it is worth remembering that the main feature of attracting any loan is the need for a subsequent repayment.

Many overly indebted companies can struggle with a harsh economic environment, especially when interest rates rise, which can often lead to bankruptcy. To analyze the capital structure of a company and determine its overall stability, the fundamental analysis identifies a number of financial stability and solvency indicators. One of them is net working capital.

Net Working Capital: Meaning, Measurement, and Optimization

Definition

A company can be confident in the stability of its financial position if it has a “safety net” in the form of net working capital. The positive value of this indicator is a key condition for the financial stability of the company, its liquidity, and solvency. Net Working Capital (NWC) is a financial measure that represents what is left from the current assets after payment of the short-term obligations.

If the company has to pay off all short-term debt at once, it should still have net working capital left. Even if all creditors demand the repayment of the current debt, the company will continue its normal operation without the threat of bankruptcy.

Formula

In order to compute the net working capital, it is necessary to deduct short-term liabilities from the amount of assets a business expects to use during this year (a.k.a current assets) at a certain date. All information for the calculation is taken from the company’s Balance sheet.

Net Working Capital: Meaning, Measurement, and Optimization

Let’s look at a Sports Bikes company and calculate its NWC using the available data. Sports Bikes has $5,000 on its bank account and $12,000 in its inventory. The accounts receivable for Sports Bikes is expected to be 15% of the annual sales. The accounts payable should add up to 18% of the annual COGS. The sales are expected to be $200,000 and COGS are expected to be $85,000.

First, we need to calculate the total amount of current assets. We can tell right away that we have $5,000 in cash and $12,000 in Inventory. To this amount, we will add the accounts receivable, which is equal to 0.15 x $200,000 or $30,000. Thus, the total value of the current assets for Sports Bikes is $47,000.

Now, let find out short-term liabilities. This would be our accounts payable account, which is equal to 0.18 x $85,000 or $15,300. We can finally find out what the NWC value is by subtracting $15,300 from $47,000. As you can see, it was relatively simple to find that the NWC for Sports Bikes is $31,700. Now, let’s look at what this number means for this company and if its financials are in a good place or not.

Analysis of net working capital

Net working capital is an indicator that is worth calculating to find out the company’s ability to repay its obligations in the short term (12 months). It can be used to calculate the “enterprise safety cushion”. Depending on the individual needs of the enterprise, its competitiveness, the scale of its activities, and market position, the required amount of working capital is determined.

It is bad for an enterprise both to have a large amount of net working capital and a small one. A large amount of net working capital indicates the inappropriate use of its own funds, and a small amount indicates that the company is not able to pay even current bills, let alone long-term ones.

If this value is below zero, then the amount of short-term liabilities exceeded the company’s own funds. Accordingly, the enterprise has nothing to pay for its current obligations. In this case, the bankruptcy of the company is doomed to happen in the near future. To prevent this from happening, it is necessary to analyze the working capital and take measures to optimize it.

For the effective use of working capital, it is necessary to analyze it according to the following indicators to identify if you have a net working capital problem and see what you can do to fix it:

  • value (positive or negative)
  • structure (a portion of cash in the NWC)
  • asset turnover (assesses the intensity of the use of working capital)
  • the profitability of the net working capital (an indicator that shows how much profit each dollar of working capital brings to the enterprise).

Working capital is a common measure of a company’s overall health. There are measures the management can take to optimize the company’s working capital. Its management plays a major role in all businesses, irrespective of their industry, size, and current situation, and performance. By optimizing various processes, the amount of tied-up capital can be reduced. The freed-up funds can be used by organizations not only to cover their obligations before other parties but also to make investments or fuel growth in new markets.

One of the examples of working capital optimization is smart inventory management. The company should keep just enough inventory to meet the needs of customers and use the remaining money for other purposes. If you have a lot of inventory hanging around, hold off on purchasing more items or producing more goods.

In addition, it offers its customers a convenient way to pay for the goods and reminds them about any upcoming and overdue payments, rewarding those who pay early. This will help the company get its invoices paid faster and have more liquid assets to cover its liabilities. Businesses can also evaluate their vendor and supplier options for potential savings. By evaluating fixed expenses, you may be able to refinance some of your long-term obligations or find less expensive options to ultimately lower your monthly payments.

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Author: Charles Lutwidge

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