What is Net Working Capital?

What is Net Working Capital?

The accounting definition of working capital is the calculated difference between the current assets of a company and its current liabilities in its statement of financial position.

It is used to estimate the company’s liquidity and a measure of its ability to meet its short-term obligations as at when due and also make enough funds to cater for the operations of the business.

The ideal situation that every business strives for is to ensure that it has current assets that trump its current liabilities as this implies that the company has enough funds to cater for its impending expenditures; thus a favorable working capital position is what every company strives for to ensure that there is enough funds to run the business.

There are different approaches to the computation of networking capital; some strategies might exclude cash and debt (reflecting current position only) or include only funds owed to the business (account receivables), inventory held for sale, and funds owed by the company to external parties (account payable).

Elements of Working Capital

The main elements of the computation of the working capital of a company are listed below:

  • Cash
  • Account receivable
  • Inventory
  • Account payable

Cash

Cash

This means the available funding that the company has to meet its expenditures as at when they fall due, some computation of working capital such as the cash ratio is used in evaluating the available cash levels of a business compared to its outstanding short term obligations in a bid to assess whether or not the company has enough cash to repay its obligations when they fall due.

Account Receivable

For a business and to maintain its operations which would mean not stalling production, there are situations where the company has to make sales on credit to suppliers who in turn make the sales to the final consumers.

Despite the import of making quick sales through credit sales, the company must exercise reasonable care in making these sales to ensure that receivables are collected on time.

Inventory

These are goods produced for the company for the sale or use in further production inventory exist in three forms, namely, raw materials, work-in-progress, and finished goods.

A company should seek to hold low stock levels to increase its cash levels; however, in the traditional computation of working capital, a high inventory would mean a positive working capital as it helps contribute to the current asset, thereby trumping the current liabilities.

Account Payables

This could exist in the form of trade credit, I.e., goods bought on credit from suppliers to the company.

Most trade credits are usually without capital and are mostly granted based on the excellent reputation that a company has amassed over the years, which has earned it credibility in the market as a company that makes the payment for goods as and when due; hence a high account payables level could mean that the company is owing funds which need to be repaid immediately to avoid ill reputation.

Factors That Affect Working Capital Needs

Net Working Capital 105

The required working capital for a business varies according to the business model the organization runs.

The factors could be subdivided into Exogenous and Endogenous factors that could affect the need for working capital for the company.

 Endogenous factors

  • Company’s Size: The size of a company tends to play an essential role in deciding the amount of working capital a company would require for day-to-day running. A large corporation would require significant working capital to ensure that the company can meet the demands of its customers while also continuing production. Therefore there is a constant need for working capital to meet its obligation.
  • Company Structure: The need for working capital is also determined by what type of business structure a business runs. The system could vary from Sole proprietorship, Partnerships, Limited liability, and Corporation. This could influence the desire for more capital to run the business as a sole proprietorship might decide against advancing credit to its customers. It is well aware of its working capital need and the relative difficulty in extra sourcing capital to meet the day-to-day running of the business. However, a giant corporation, on the other hand, might be able to source capital quickly due to its rich credit history and renowned name in the business world.
  • Strategy: The company’s management might have long to short-term plans that can influence the need for working capital. Most businesses have standard credit days that they grant their customers, which might vary accordingly. A company that runs the Just-In-Time inventory system might also have an excellent working capital system as it hardly holds stock; thereby, no turnaround time for supply and capital is freed up for the continuous running of the business.

Exogenous Factors 

These are factors that are outside the control of the organization but influence its ability to meet its working capital needs:

  • Access and availability of banking services: The accessibility of credit from commercial banks is always a factor when evaluating working capital needs, as banks are not always inclined to granting facilities to new businesses and would instead lend to established names in the industry to guarantee that the facility that can be duly repaid as and when due.
  • Level of interest rates: The interest rates attached to obtaining loans from financial institutions also plays a crucial role in determining working capital needs as there needs to be a trade-off between the cost of money and the intended use; meaning that the benefits should outweigh the benefits as the high-interest rate would affect the profitability of the business thereby threatening its continuity.
  • Type of industry and products or services sold: A manufacturing concern would always need additional working capital to meet its short term obligations as its account receivable might be high as it makes credit sales, thereby making for a longer working capital cycle, leading to actual cash shortage in meeting the day to day running of the business; a construction company on the other hand who might have secured advance payments for its services would have to carry out its project with the already provided funding by the principal.
  • Macroeconomic conditions: Macroeconomic conditions such as inflation rate, exchange rate, aggregate demand, etc., might influence the working capital need of a company like this, too, assists the company in evaluating the benefit that could be derived from accessing credits in a hyperinflationary economy.
  • Size, number, and strategy of the company’s competitors: The economic power of competitors in the industry also guide the decisions on the working capital need of a company, as a company whose competitor is availing credit to the consumer might have to adopt the same strategy as well to remain competitive and not lose its customer base to other companies in the industry.

Managing Liquidity

Liquidity

Effectively managing the company’s liquidity would result in the company having sufficient cash resources to meet its ordinary business cash requirements while also providing adequate funding for contingencies that may arise.

The ability of a company to repay its obligations when they fall due serves as a measure of its creditworthiness which could serve as a guarantee for the business continuity as it is essential to maintain the faith of trade creditors and banks by ensuring that they can meet their obligations accordingly.

A company with low liquidity might be forced to face financial distress, which would call its going concern propensity into question.

However, excessive cash means that the business is overcapitalized as it has too much liquidity – funds in non-earning assets that are not relevant for the company, which could easily indicate a poor allocation of resources.

A company is considered to be managing its liquidity effectively when its liquidity level is appropriate. It can quickly and efficiently generate cash resources to finance its business needs which would assure its liquidity position.

Managing Accounts Receivables

A company is expected to grant its customers flexibility and commercial credit, which would avail them the flexibility with which to make payments for the goods and services offered.

This should be effectively managed to ensure that there are enough cash levels to meet the operational need of its business operations.

A company’s credit terms are determined based on the following criteria credit terms to be offered based on the financial strength of the customer, the industry’s policies surrounding credit, and the competitors’ actual policies, which need to be evaluated to ensure that the business does not lose its customers to the competition.

Credit terms may be ordinary, which implies that a customer is granted credit days within which he is expected to make payments on the invoice; days might range between 30 to 90 days.

The company’s policies would determine the necessary terms, such as payment before delivery, pay on delivery, bill-to-bill, or periodic billing.

Managing Inventory

inventory managment

A company must maintain an appropriate inventory management system that aims to ensure that the company holds adequate inventory levels to meet the demands of its customers without having to invest excessively in the assets to meet the fluctuation in demand of its goods.

A company would not want to keep excessively high inventory levels as this is considered a poor management system as capital would be tied down coupled with the fact that there is also increased risk of inventory remaining unsold and potential obsolescence eroding the value of held inventory.

On the other hand, the company should also avoid shortages in inventory levels which could result in lost sales and affect customer loyalty if goods are not available on demand.

Therefore, the company would have to employ the right inventory management system that best fits its business.

Managing Short-Term Debt

Concerning liquidity management, the management of short-term financing should also be focused on ensuring that the company has in its coffers enough liquidity to finance its short-term operations without taking on excessive financial risk.

A company should adopt a financing that involves selecting the suitable financing instruments and evaluating the returns of the funds accessed via each instrument to effectively manage resources.

Most accessed funding sources include but are not limited to regular credit lines, uncommitted lines, revolving credit agreements, discounted receivables, collateral induced loans, and factoring.

A company has to ensure enough access to liquidity when there is a high demand for cash available. E.g., a company setting up a revolving credit agreement well above ordinary needs to deal with cash contingencies.

Managing Accounts Payable

Accounts payable is a position that comes from benefiting from trade credit granted to the company by its suppliers, which is primarily as part of the normal operations.

The company should strike the right balance between early payments and commercial debt as this could be a good source of spontaneous financing.

A company making quick payments on trade credit might derail the benefits derived from spontaneous funding. It may unnecessarily reduce the liquidity available, which could be utilized in productive ways for the business.

However, excessively delayed payments might erode the company’s good reputation. Commercial relationships with its suppliers and a high level of commercial debt could reduce its creditworthiness, making it difficult to source extra cash to meet its needs.

Net Working Capital Formula

Net Working Capital Formula

Few methods could be adopted for the computation of working capital; however, this depends on elements that the analyst intend to include or exclude from the value 

Formula:

Net Working Capital = Current Assets less Current Liabilities

or,

Formula:

Net Working Capital = Current Assets (less cash) – Current Liabilities (less debt)

or,

NWC = Accounts Receivables (Debtors) + Inventory (stock ) – Accounts Payable(creditors)

The first formula covers every element of current assets and liabilities without expunging any aspect; this makes it the broadest as it allows for a review of all factor shifts.

The second formula eliminates the cash element of current assets while also eliminating the debt portion of the current liabilities to evaluate the business position without the component of the most liquid form of existing assets and liabilities.

The third formula is narrow in its evaluation. And could also be called the working capital cycle. It evaluates the estimated period it will take for a business to realize its receivables and meet its impending payments on account receivables.

Setting up a Net Working Capital Schedule

Net-Working-Capital

Below are the series of steps employed by an analyst in evaluating networking capital using a schedule in Excel.

Step 1

The first step is to include a reference for sales, cost of goods at the top of the working capital schedule from the income statement for all relevant periods, as these would be used later to calculate drivers to forecast the operational capital accounts required.

Step 2

Next is to lay out the relevant balance sheet accounts under sales and cost of goods sold. Then separate current assets and current liabilities into two sections.

It is important to remember to eliminate cash under existing assets and current portions of debt from current liabilities. To enhance clarity and consistency, accounts are to be laid out in the order they appear on the balance sheet.

Step 3

After that, compute the subtotals for total current assets (excluding cash) and total non-debt current liabilities. The difference between both would result in networking capital available to the company.

If the under listed would be valuable, you then create another line to calculate the variation that results in an increase or decrease of net working capital compared between two periods

Step 4

You can then prepare the schedule with historical data, either by referencing the relevant data in the balance sheet or by entering hardcoded data into the networking capital schedule.

In a situation where this has been prepared with future forecasted periods already available, all you need to do is populate the program with forecast data by referring to the items in the balance sheet.

Step 5

If future periods for the current accounts are unavailable, you would need to create a section to outline the drivers and assumptions for the main assets to be included in the balance sheet.

The use of historical data to calculate drivers and deductions for future periods. You can then use the prepared drivers and assumptions to estimate future values for the line items by computing them correctly.

Drivers Used for Net Working Capital Accounts

Net Working

Below is a list of assumptions used in a financial model for the determination of net working capital:

Accounts Receivables: Accounts Receivable Days

Inventory: Inventory Days

Other Current Assets: which measures Percentage of sales, growth percentage, fixed amount, or increasing amount

Accounts payable: Accounts Payable Days

Other current liabilities: % sales, growth%, fixed cost, variable element

Accounts receivable days, inventory days, and accounts payable days all rely on sales or the cost of goods sold to calculate. If either sales or COGS is unavailable, the “days” metrics cannot be calculated.

In the event of this, it might be a lot easier to compute the  accounts receivables, inventory, and payables by analyzing the past trend and estimating a future projections and value.

Summary

Working capital management is essential in balancing the movements related to cash, trade receivables, trade payables, short-term financing, and inventory, as this ensures that a company has adequate resources that guarantee operational efficiency.

The cash levels that a company holds should be sufficient to deal with ordinary or small unforeseen contingencies; however, it should not be too high to prevent inefficient allocation of capital.

The grant of commercial credit to customers should be adequately used to balance the need to maintain sales and healthy business relationships with customers and the importance of limiting its exposure to customers with low creditworthiness so as not to place the business’s ability to repay its obligations in jeopardy.

The company should also manage short-term debt and accounts payable to allow the company to achieve enough liquidity for ordinary operations and contingencies without an excessive increase in financial risk arising from borrowing.

Good inventory management should be adopted to ensure that there are enough products to sell and materials for its production processes while avoiding excessive accumulation of inventory which could lead to obsolescence.