Net working capital is the difference between assets and liabilities. When you add the amount of cash, inventory of material goods including finished products, and money owed to you, then subtract your unpaid debts and current expenses, you get your NWC.
NWC reflects the financial health of a company, representing its liquidity and operational efficiency. A business has resources to invest and expand with a positive NWC. For a business to have more liabilities than assets is a fiscal risk and it may end up in a troubling position and unequipped to survive. Negative NWC is when the ratio of assets to liabilities is less than 1.
A positive NWC shows that a company can sustain its present operations and spend on growth. Though, if NWC is extremely positive, that can actually be a negative indicator that the business maybe hoarding inventory or not investing its returns. Low NWC may signify distress. An acceptable NWC is on par with industry average, either aligning or a slight amount higher.
When we discuss “current,” we refer to a time frame within twelve months. Assets are owed or available within twelve months and liabilities are due within the same. “Asset,” means cash, accounts receivable, inventory, and other reserves expected to be liquidated or turned to cash in less than one year. “Liabilities,” are accounts payable, wages, taxes, and the current portion of long-term debt due. All of these appear on a corporate balance sheet.
Factors to be considered are the execution of new projects or investments will reduce cash flow numbers. If customers are slow to pay invoices, this can affect your ledgers. Putting a little pressure on those collections, or even on your suppliers for a better deal, can help increase your ratios. Another way to keep cash in reserves is to delay your own payments on debts, but this is usually not recommended.
NWC is relevant because it keeps a business in check and solvent. If a company invests all of its gains at once, it may not have enough to cover a looming overhead. Conversely, if not enough is reinvested a business might stunt its own growth or become stagnant. NWC shows how the green is flowing and helps determine the proper balance to keep your business in the black.
