Understanding the calculation of net working capital will show you what the importance of liquidity is to a company. A healthy working capital also indicates that a company is in good health, and can meet all its expenses with ease.
The net working capital is a figure that needs to be calculated by someone who is studying the balance sheet of a company, and a number of conclusions can be derived from the figure that comes up. This information is very important, and is useful to different people in different ways.
When a company releases its 'Income Statement' and 'Balance Sheet', there are many accounting values of assets and liabilities that it needs to display to the world.
These values help shareholders understand how well the company is working; it helps investors decide if they should buy the stocks of the company or not; and it helps the managerial team understand what state the company is in, and what can be done to improve its revenue and profitability.
What is Working Capital?
First, it is necessary to understand what working capital exactly means. In short, this is a figure that gives an indication about the short-term financial health of the company. It shows the ability of the company to meet its short-term goals and expenses, and how well they manage their resources on a day-to-day basis.
Every company has some short-term liabilities and short-term assets, and in most cases, these assets are used to pay off these liabilities. This ensures that the company works smoothly everyday, without feeling a loss of short-term liquidity.
Compare the situation to that of an individual who has invested a million dollars in a bank. The money in the bank fetches him a steady income at some rate of interest, and he can also use it to buy big items when he wants.
But he also needs some liquid cash and smaller amounts to meet his day-to-day expenses like food, water, shelter, and other items. This is what working capital is for a business organization.
Current Assets and Liabilities
This is another concept that is necessary to understand before deriving the net working capital. Current assets are all the assets of a company that can be converted into liquid cash within a period of one year. Thus, if the company finds itself unable to pay off certain expenses, it can sell these assets and get some money very soon.
Current assets include cash reserves, inventory, accounts receivable, prepaid expenses, marketable securities, and other liquid assets. This value is important for calculating the net operating working capital formula of the company.
Current liabilities are the exact opposite of current assets, and these are all debts and obligations that need to be repaid and resolved within one year. All bills to suppliers and creditors fall under this category, and these are expenses that need to be met, and the money for this comes from the current assets.
Examples of current liabilities are accounts payable, short-term debt, accrued liabilities, besides many others.
Calculating Net Working Capital
The formula for net working capital is:
Current Assets - Current Liabilities Thus, it signifies the ability of the company to meet short-term expenses with short-term assets. A positive working capital indicates that a company can meet its daily expenses with ease.
If there is too much of a difference between the two values, it signifies that too much money is lying in reserve, and it can be applied elsewhere. Thus, better means of financial planning and financial management need to be undertaken.
On the other hand, a negative working capital means that the expenses are more than the ability to meet them. This could put the company in trouble if all debts suddenly need to be repaid. The company should then take some steps to increase the value of current assets and to ensure that more liquid cash is available.
Failure to recognize this problem could lead to Chapter 11 bankruptcy. Investors also scrutinize the working capital ratio before they invest, so that they can get a fair idea about the firms operational efficiency.
All companies must strive to achieve a positive change in net working capital over a period of time. This will indicate what direction the company is heading in, and how well the asset management is being handled by its management.