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For a company to function and run its operations seamlessly, it’s important that a business owner keeps an eye on net working capital. Net working capital is nothing but the difference between a company’s current assets and current liabilities. When a positive net working capital is derived, it means that a company has enough funds to take care of their current financial needs or obligations. Not just that, but a positive working capital also helps business owners forecast their future and make wise investment choices.
As mentioned earlier, net working capital is derived by taking the difference of current assets and current liabilities. Here’s is the mathematical equation to understand the derivation of net working capital:
You can also use another formula to calculate your company’s net working capital.
After understanding the definition and the formula to derive your company’s net working capital, how about we give you an example for better understanding? We will be drilling down to each of the elements that help us calculate net working capital of a company.
These include cash and other assets that are expected to be converted to cash within a year. They could be: Cash and cash equivalents, marketable securities, accounts receivable, inventory and supplies, prepaid expenses, other liquid assets.
Now, say for example, your company has cash and cash equivalents of INR 1,10,000, accounts receivable of INR 50,000, and other prepaid expenses that are worth INR 30,000. Sum of all these will give us the total current assets that we will consider to calculate NWC (net working capital).
Current assets = 1,10,000+50,000+30,000 = 1,90,000
Current liabilities are a company's debts or obligations that are due within one year or within a normal operating cycle. Some examples of current liabilities; money owed to suppliers in the form of accounts payable, short-term loans, lines of credit, accrued liabilities, and other debts such as credit cards, trade debts, and vendor notes.
Now, say for example your company has a short-term loan of INR 15,000, accounts payable of INR 8,000, and accrued liabilities of INR 4,000. Sum of all these will give us the total current liabilities that we will consider to calculate NWC (net working capital).
Current liabilities = 15,000+8000+4000 = 27,000
Now calculating net working capital is super simple. Simply subtract the total current assets and current liabilities.
Net working capital = 1,90,000 - 27,000 = 1,63,000
The net working capital ratio is nothing but a percentile representation of a company’s current assets and liabilities. While NWC is calculated by subtracting current assets and current liabilities, the ratio is can be arrived at by dividing assets by liabilities. This ratio, similar to NWC, helps determine whether your company has enough current assets to cover the liabilities.
(Current Assets) / (Current Liabilities)
Thus, the mathematical equation to calculate net working capital ratio is as follows:
Ideally, the optimal ratio should be between 1.2 – 2 times the amount of current assets to current liabilities. If you see a higher number, it could mean that your company isn’t using its current assets to its maximum.
The way you manage working capital signifies the success of your business. The businesses with stronger working capital have enough cash cushion to seed further growth and expansion. A positive working capital ratio indicates the business is well-positioned to pay its short-term debts and invest further. While a negative working capital reflects the financial difficulties of the business to settle its short-term debts and on the verge of closure if the trends continue for a longer time.
A high working capital ratio is not always a good thing for business. This indicates the business has too many inventories and is struggling to sell those. It may also indicate the business takes a long time to convert its accounts receivables into cash. It also represents you have extra cash that you should invest in other areas of business. Holding extra by not investing is not a smart decision of your money.
In the end, it all boils down to how much working capital is enough? The need for working capital is directly linked to the growth of the business. You need to answer this question considering serval attributes of working capital discussed above.