Net Working Capital

Net working capital can be described simply as the difference between assets and liabilities, less any current borrowings. The amount of net working capital in a business is a direct result of three factors – operating income, assets, and liabilities. Operating income is money made or lost from the business, while net working capital refers to the difference between assets and liabilities, less any current borrowings. Non-financialized operating funds are those funds that do not include inventory, accounts receivable, accounts payable, gross profit, and net gain/loss. The term non-financialized is primarily used in commercial real estate loans; however it can also apply to purchase and sales of property and equipment.

The purpose of a company’s short-term financial health is to ensure that no unexpected financial obligations have to be met. For most businesses, this means that a company must be able to repay its debts in a reasonable amount of time, or else experience significant consequences. For these reasons net working capital plays a key role in ensuring that short-term business operations are successful.

There are two primary methods for measuring net working capital: net income and net worth. Net income is a sum of all cash collections and payments, while net worth is an estimate of a business’s value based on current tangible assets, including equipment, goodwill, and fixed assets. Both measures are important in making financial decisions. The method of measurement will ultimately depend on the specific needs of the company.

One of the major indicators of liquidity is a current asset balance, which compares current assets to current liabilities and net worth. The larger the net working capital figure is, the more liquid the company is. Liquidity is a key indicator of a company’s ability to generate the funds necessary to satisfy its liabilities and obligations. A company’s liquidity is also a function of its net working capital – the net amount it can owe to its creditors, plus the net amount it can receive from them – as well as the net amount it can pay to them once a month.

Another factor contributing to a company’s net working capital measure is the net amount of cash available to fulfill its short-term obligations. Under most situations, this refers to the amount of cash readily available to meet an immediate cash request. For example, if a manufacturing firm needs to obtain raw materials in a hurry to meet a customer’s deadline, it may want to obtain them before its inventory hits its limit. To do so, it would need to immediately sell its surplus inventory – and the immediate sale of its inventory would translate into immediate cash.

The final component of a company’s net working capital measure is the net amount of accounts receivable. Accounts receivable represents the income that customers purchase from the business – usually in the form of credit payments. When a customer requires more of a product than it has on hand, it will buy additional items. The resulting net effect is that the firm must pay money to maintain its accounts receivable balance.

Net working capital measures are derived by calculating the net amount of current assets minus the net amount of current liabilities – or net current liability. Under most current asset-based valuation methodologies, net working capital occurs when current net worth is subtracted from net current liability; that is, the value of the company’s net worth is less than the total value of its liabilities (both current and long-term). In current liability-based valuation, net working capital measures are typically calculated by first dividing current assets by current liabilities; then subtracting the former from the latter.

Another method of gauging net working capital involves the cash flow perspective. Under this method, current liabilities are replaced by accounts receivable and current assets by accounts payable. The difference between the two measurements is the net effect of the company’s liquid assets, including current inventory and equipment, against its obligations, which come in the form of accounts payable. This measure is helpful because it allows liquid investments to be compared with overall investment strength. Liquidity is important because it indicates how well cash flows are managed, allowing businesses to estimate their liquidity needs. Liquidity, however, is not equivalent to net working capital; a company’s level of liquidity can be an indication of its ability to generate short-term profits, but it cannot serve as a basis for predicting the company’s long-term viability.