Net Working Capital - Why it is important and how to calculate it
Working capital and cash flow are two variables that help evaluate whether businesses can endure an unanticipated crisis. These two measures show several facets of an organisation's financial health. So, what is net working capital?
Working capital is the difference between the company's current assets, such as cash and inventory, and its current liabilities, such as payroll, accounts payable, and accrued expenses. Essentially, net working capital is the difference between assets that can be converted into cash in less than a year and liabilities due to be paid in less than a year.
Net working capital is used to gauge a company's short-term liquidity. Also, it is used to understand how well the organisation can manage its assets. Consider a business that has Rs 100,000 in net working capital. It signifies that its current assets are Rs 100,000 greater than its current liabilities. Companies may also have negative working capital.
Net Working Capital Formula
We subtract a company's current assets from its current liabilities to determine the net working capital.
Thus, the net working capital formula is:
Current Assets - Current Liabilities = Working Capital.
Working capital is usually expressed as a monetary amount.
Consider a company with Rs 100,000 in current assets and Rs 30,000 in current liabilities as an example. As a result, the company will have a working capital of Rs 70,000. This indicates that the business will have Rs 70,000 available if it urgently needs to raise capital.
Positive results in a working capital calculation indicate that the company's current assets exceed its current liabilities. Thus, the corporation has more than enough assets to repay its short-term debt.
A negative working capital indicates that not all the company's current liabilities can be covered by its current assets. In other words, short-term expenses exceed short-term resources for the company. So, negative working capital is a sign of insufficient liquidity and poor short-term health.
Types of Net Working Capital with Example
The following are the various types of working capital:
1. Working Capital Overall
Gross working capital is the sum of the current assets of the business. However, it doesn’t truly reflect a company’s liquidity position like net working capital since it doesn’t consider the current liabilities.
2. Permanent Working Capital
The bare minimum of capital needed to maintain operations smoothly is known as permanent working capital. It can further be bifurcated as regular working capital and reserve margin working capital.
3. Regular Working Capital
Businesses need a certain level of regular operating capital to cover their daily expenses. For instance, the money required to pay salaries, raw materials, and wages falls under this category.
4. Reserve Margin Working Capital
The money set aside in addition to the ordinary working capital is known as reserve margin working capital. This money is kept aside to tide over unforeseen occurrences like storms, natural disasters, floods, pandemics, etc.
5. Variable Working Capital
The capital invested in the company for a brief period is known as variable working capital. This capital varies depending on the company's size or changes in its assets.
Working capital is crucial for businesses because it keeps them afloat. Theoretically, even profitable companies can go out of business. After all, a company cannot rely on paper profits to pay its debts. These debts must be settled with readily available cash.
Working capital disregards the kinds of underlying accounts. Consider a business where the entirety of the existing assets is made up of accounts receivable. Despite having solid working capital, the company's financial stability depends on whether its customers will pay and whether it can generate short-term cash.
High working capital, however, isn't always a desirable thing. It could mean that the company has excessive inventory. In this case, the company could be burning resources towards borrowing capital costs.
Accounting software help manage the working cash, which is crucial for the health of a business. You must have positive working capital to invest in growth and fulfil immediate responsibilities, such as paying suppliers and loan interest. Negative working capital, on the other hand, is a warning sign that a company may have trouble staying afloat.
Q. What distinguishes gross working capital from net working capital?
Gross working capital is the sum of all current assets. It is almost always higher than net working capital, which is derived by subtracting current liabilities from current assets. Net working capital may have either a positive or a negative value.
Q. What is the sole objective of employing net working capital?
Working capital is used to finance operations, service short-term debt and maintain a healthy level of liquidity. Even when companies may be experiencing cash flow issues, they must continue paying their suppliers and staff and meet obligations like taxes and interest payments.