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Calculating Net Working Capital

Net working capital, also called net working capital (NWC), is the gap between a business’s current assets, including cash, accounts receivable, inventory and raw materials, and its future liabilities, including accumulated loan debt, property loans and leases. It is also referred to as the margin for equity finance. For a small business, a net working capital balance is sufficient to finance operating expenses and generate cash for short-term financing needs.

Net working capital is an integral part of any business. A company may have net working capital that is sufficient to pay wages and salaries for all employees and buy necessary equipment and supplies, but if that capital is not available when payments are due, the company may be unable to continue operating. A company may have net working capital equal to its payroll balance plus cash paid into the company’s accounts receivables plus short-term debt. But a company may have net working capital that is less than its payroll balance and payable capital plus long-term debt and may be unable to pay obligations when those obligations are due.

A company’s ability to make payments when it is required is called liquidity. A firm must have enough liquid cash on hand to meet its daily operating requirements, including expenses, inventory, rental expenses, capital expenditures, and cash payments for its short-term debt and purchases. Net working capital represents the difference between net current assets and current liabilities. A company’s net working capital balances are usually based on net book or factor income and depreciation charges. Net working capital increases with the total assets of a firm and decreases with net debt, net worth and net debt/equity. A firm’s net working capital level typically increases over time due to net additions of assets, net dispositions of assets and net receipts of capital assets.

Net working capital results from the use of cash by a firm to purchase goods and services, make loans and invest in certain projects and events, including repurchases of retained earnings, payments made by customers to the firm for products or services and payments made by the firm to other firms for investments, assets and equity. Most financial statements are prepared based on an assumption of a constant cash flow, that is, cash generated from operations should continue indefinitely. Based on this assumption, a company may calculate its net working capital at a constant level over time or on a historical average. However, actual financial results may vary significantly depending on a variety of factors. These factors include:

Revenues. How much revenue a firm earns usually determines its net working capital. Cash generated from sales usually results in higher cash flow. Companies that generate most of their revenue from sales can experience a reduction in net working capital as their profits increase. A company that generates high levels of foreign sales also experience relatively low levels of net working capital.

Liquidity. A company’s net working capital is negatively affected by the amount of liquid capital available to finance operations. A company with excess short-term liquidity may have trouble meeting its short-term obligations, if the market value of its short-term liabilities exceeds its net tangible assets.

Current Assets. A company’s net working capital is calculated by adding current assets to the total value of its net working capital. The current assets needed to finance an operating expense are called current liabilities. The current liabilities less the total current assets determine net working capital. The company may not actually need to borrow the entire amount of its current assets; however, it must have sufficient amounts of existing liabilities to cover its expenses.

Long-term assets. Net working capital is also calculated by subtracting current assets from the total value of its long-term assets. The difference, net worth, between net worth and the current value then becomes the net worth of the company. The long-term value of the company’s net worth represents all future cash flows that a business could potentially receive based on the current value of its assets and liabilities. The company’s capacity to generate future cash flows is an important consideration for investors who want to obtain a higher price for their stocks.