Working capital is one of the most critical parts of a business’s finances. It shows how much money a business has to run day-to-day. Working capital also shows whether a business can pay its bills on time. So, good working capital depends on good financial planning.
The primary way to measure cash flow is by the net working capital (NWC). It tells in detail how stable and financially sound a company is. Net working capital is also helpful in managing assets. This is important if the firms want to do well in the future. By looking at the NWC formula and what it means, you can make the best choice when things are hard.
Importance of Net Working Capital
Net working capital is a key part of a company’s ability to stay liquid. You can better meet immediate needs when you have more net working capital. A business should always have enough money to cover costs for a whole year. The net working capital of a company is bigger if it has more cash on hand. So, a company with a positive NWC is in a good position financially. Also, a negative NWC shows that money is tight.
- NWC helps a company pay off its current debts
- Net working capital tells suppliers, investors, and customers about a company’s liquidity
- A high NWC shows you know how to manage resources and capital well
- Net working capital helps a company grow in the future
How is Net Working Capital Made Up?
Net working capital is a great way to determine how well a business is doing financially. When you figure out your net working capital, you need to know the following:
Current assets are cash and other assets that can be turned into cash within a year. Current assets include cash, accounts receivable, inventory, costs that have already been paid, and other liquid assets.
For example, your business has cash and cash equivalents worth INR 1,10,000. The business also has INR 50,000 in unpaid bills and INR 30,000 in other costs. All of these make up the current assets as a whole.
1,10,000 + 50,000 + 30,000 = 1,90,000 (current assets.)
Liabilities that are due shortly are called “current liabilities”. Accounts payable, short-term loans, liabilities that have already been paid, and other debts are all examples.
Say your business owes INR 4,000, has INR 8,000 in accounts payable, and owes INR 15,000 on a short-term loan. The total amount of current debts is $15,000 plus $8,000 plus $4,000, which is $27,000.
How Do You Figure Out Your Net Working Capital?
Using the net working capital formula, you can determine how well the business can meet its short-term obligations. Use these steps to figure out your net working capital:
- Add up all of the current assets listed on the balance sheet, like cash, liquid assets, and accounts receivable
- Add up all the items on the balance sheet that are listed as current liabilities. It includes wages, interest, sales tax, and other bills that need to be paid
- Add up your current assets and subtract your current debts. The last number shows the net working capital of a business
Net Working Capital Formula: Current Assets – Current Liabilities
By excluding cash and loans, the Net Working Capital formula is
NWC = Current Assets(minus cash) – Current Liabilities(minus debts)
Net Working Capital Example
Imagine a local store as an example. Its current assets and liabilities are as follows:
- Cash in hand: ₹ 25,000
- Liquid asset: ₹ 15,000
- Accounts Receivable: ₹ 10,000
- Accounts Payable: ₹ 9,000
- Accrued Expenses: ₹ 5,000
- Other Debts: ₹ 10,000
You will now apply the Net Working capital formula to get the Net Working Capital.
Net Working capital formula: Current Assets – Current Liabilities
= ₹50,000 – ₹24,000
The working capital is positive because the current assets are higher than the current liabilities. This shows how the store pays off all its debts with its current assets. This shows how liquid the company is in the short term.
How to Increase Net Working Capital?
The following ways to increase net working capital work well:
When you spend money on a project, that’s the start of your operational cycle. When you get paid for a job, the capital cycle is over. As little time as possible should go by between the operational and capital cycles. If you wait weeks to send out invoices, it will hurt your cash flow and make it take longer for you to get paid.
Streamline Production Processes
Net capital working is changed by having too much inventory. So making the production process more efficient will help you sell more every day. A high selling rate keeps there from being too much stock and makes the net capital working go up.
Use Your Accounts Payable
Keeping good relationships with your debtors is often the best way to increase your net working capital. To do this, you must keep your credit score as high as possible. If you have trouble with cash flow, you might be able to negotiate longer payment terms if you have good credit and helpful contacts. But this is not a long-term solution to money problems that keep coming back.
Transparency in the Process of Billing and Reporting
If you are honest about billing and monitoring, you will see how your business is doing financially. With this method, you can do something if you have a gap in your cash flow or an unexpected expense.
What Happens When Net Working Capital Changes?
The cash flow of a company can be affected by changes in its net working capital. Changes in net working capital are caused mainly by new projects, investments, and the use of cash.
The net change in working capital is very important for keeping track of changes in cash flow from year to year. Don’t forget that your net working capital will decrease if you take out big loans or lease equipment. By looking at changes in net working capital, you may be able to figure out what’s wrong and fix it to make more money.
What are the Pros and Cons of Net Working Capital?
Consider the pros and cons below when you figure out your net working capital.
- You have more freedom if you have more net working capital. It lets you take care of customer orders, grow your business, and put money into new products and services. It also helps your business when it needs a little more money.
- Net working capital is essential, but if you have too much of it, it could slow the growth of your business. A net working capital balance sheet shows that a company either doesn’t know about growth opportunities or isn’t going after them.
Negative working capital has a lot of harmful effects, such as the chance of paying suppliers late. If you can avoid paying your bills late, you might be able to lessen the impact. Repeated overspending or an increase in public debt hurts your business.
Net working capital is a way to measure a company’s ability to pay its bills. If your company has positive net working capital, it has enough cash to pay its short-term debts or put some money toward growth. Working capital calculations also make it easy to figure out the cash flow of your business.
Last but not least, your company’s success or failure will depend a lot on how well you use your assets. You can learn more about net working capital on the Piramal Finance website. It will help you judge the quality of their goods and services.