Net Working Capital is the net of total current assets of an entity with its total current liabilities. When we want to assess the liquidity problems in the company, net working capital is one of the most important items to be included.
Sometime we use this ratio to assess how efficiently the company use its current assets. Two main importance items involved with net working capital calculation are current liabilities and current assets.
If current assets are higher than current liabilities, that mean the company may have enough fund to support its liabilities and operation costs.
And if, current assets are smaller than current liabilities, then entity might face liquidity problems soon.
Related Article: Interest Coverage Ratio
Let move to the formula,
It is quite straight forward to calculate Net Working Capital : Total Current Assets – Total Current Liabilities
Below is the list of Current Assets. Such assets are generally the liquid assets that could convert into cash easily.
However, some assets still depend on the current performance of the business and external factors. For example, cash and cash equivalence is easily convertible into cash.
But, receivables, sometime easy and sometime even more difficult than inventories. That why I say it is depend in the external environment and internal control.
Managing Working Capital of the company could be difficult job and it is becoming very importance one.
For example, cash collection, negotiation with bank to get overdraft, negotiation with suppliers to get better credit status could be difficult.
As we can see the formula, the working capital Net Working Capital is the net off between current assets and current liabilities.
So if I ask you back what are the working capital of the company? I mean say you list items that you think it is the working capital of the company.
The answer is, current assets are working capital of the company. And when we offset this with current liabilities, we called it Net Working Capital.
Please note, Net Working Capital is different from Working Capital Turnover.
Here they are,
- Cash and Cash Equivalence
- Raw Material
- Work in Progress
- Account Receivable
- Others Current Assets
Here are the List of Total Current Liabilities
- Account Payable
- Short-term borrowing
- Interest Liabilities
- Advance from owners
You probably feel these two things, liquidity problems and efficiently assessment are conflict right ?
One is measuring the liquidity and one measure the efficiency. Well, that is right.
Too high Net Working Capital mean the company does not manage its company assets properly. We can say the company has too high idle current assets.
These current assets could not help the company to grow like when we invest those assets. However, too low Net Working Capital mean the company could face the risk of bankruptcy in the near future.
Another disadvantage of low Net Working capital is that the company might not be able to pay account payable and result penalty. Penalty is bad thing, but if the supplier stop to supply goods or offering credit.
That would cause a lot of problems. Especially, operation. Without materials, all of the production process are stuck. Getting trust back from suppliers could be the difficult tasks to do.
Measuring the Net Working Capital as the serious factor in evaluating the company’s liquidity problem and measuring the performance could be the bad idea.
You know why? What is your thought when you see the company has negative net working capital.
Here some idea. for example, management of one of the company keep net working capital very positive.
And the main reason is that board director of that company use working capital as one of the most importance performance indicator as the result of their concern about company liquidity problem.
Because of this concept, management intend not to reinvest in the new machinery. They intend to keep and use the one. That is too bad for performance management of the company right?
Now, you already know the concept of Net Working Capital,
Example: Net Working Capital
ABC has the following transactions:
Current Assets: USD 1,272,000
- Cash and Cash Equivalence = USD 20,000
- Raw Material = USD 500,000
- Work in Progress USD 600,000
- Account Receivable USD 600,000
- Advance USD 6,000
- Deposit USD 70,000
- Prepayment USD 6,000
- Others Current Assets USD 70,000
Total Current Liabilities : USD 1,243,000
- Account Payable : USD 500,000
- Short-term borrowing : USD 600,000
- Accrual : USD 66,000
- Interest Liabilities : 7,000 USD
- Advance from owners : USD 70,000
Therefore, Net Working Capital is USD 29,000 (USD 1,272,000 less USD 1,243,000)