Net working capital is like lifeline of any business entity. Technically, Net working capital refers to difference between current assets and current liabilities. In general, Net working capital is also referred to as working capital. We will discuss here the concept of net working capital and its importance in details.
Defining net working capital
Any business capital or money is used two ways – either to create capital assets or day-to-day operations. If it is used for capital asset creation, it is funded by long term source of fund like promoter’s contribution, term loan etc. If it is for day to day operation, it is funded by short term source of fund like market credit, promoter’s money, bank borrowing, etc,
Assets created from short term source of funds are raw material, semi-finished goods, finished goods, bank deposit, cash in hand and receivables from customers. These are commonly known as current assets. Current assets are economic benefits that the company expects to receive within the next 12 months.
The source of fund for operation like market credit and bank borrowing are commonly known as current liabilities. Net working capital refers to difference between these current assets and current liabilities. Current liabilities are simply all debts a company owes or will owe within the next twelve months.
The amount of working capital required by a company depends on operation. Some sectors that have longer production cycles may require higher working capital needs as they don’t have the quick inventory turnover to generate cash on demand. Alternatively, retail companies that interact with thousands of customers a day can often raise short-term funds much faster and require lower working capital requirements.
Calculation of Net Working Capital
As it has already been defined, net working capital is difference of Current Assets and Current Liabilities. For example, if a company has current assets of ₹1 lakh and current liabilities ₹0.30 lakh, then net working capital is ₹0.70 lakh. It means, the company has ₹0.70 lakh at its disposal to deploy in business operation. Minimum Net working capital stipulated is 25% of total current assets as stipulated by RBI.
Components of Net Working Capital
The components of working capital are given in the balance sheet of the company. Some of them are discussed below:
Components under Current Assets
- Cash and cash equivalents: All of the money the company has on hand or in bank including uncleared cheque.
- Inventory: The stock of raw materials, consumables, goods in process and finished goods constitute inventory.
- Accounts Receivable: All the claims for goods or service sold excluding the long pending doubtful recovery.
- Notes Receivable: All of the claims to cash for other agreements, often agreed to through a physically signed agreement.
- Prepaid Expenses: All of the expenses paid in advance like raw material advance, employee advance, tax advance etc. These may be difficult to encash, it case of difficulties, they still constitute as current assets.
- Others: Any other short-term asset. An example is some companies may recognize a short-term deferred tax asset that reduces a future liability.
Components under current Liabilities
- Accounts Payable: All unpaid invoices to vendors for supplies, raw materials, utilities, rent, or any other operating expense owed to an outside third party.
- Wages Payable: All unpaid accrued salary and wages for staff members.
- Current Portion of Long-Term Debt: All short-term payments related to long-term debt. Imagine a company finances its warehouse and owes monthly debt payments on the 5-year debt. The next 12 months of payments are considered short-term debt, while the remaining 9 years of payments are long-term debt. Only the 12 months is included when calculating working capital.
- Accrued Tax Payable: All tax payable to tax authorities irrespective of period.
- Dividend Payable: Unpaid dividends to shareholders where dividend payments has been declared.
- Unearned Revenue: All capital received in advance of having completed work. Should the company fail to complete the job, they may be forced to return capital back to the client.
Interpretation of net working capital
- It is the measure of a farm’s liquidity position and short-term financial health which is indicated by the ratio of current assets and current liabilities.
- If the value of the ratio is below 1, it indicates higher current liabilities and less liquidity. If it is above 1, it indicates higher current assets and higher liquidity. On an average this ratio should be around 1.3:1
- However, high net working capital may not always be a good thing. It might indicate that the business has too much inventory, not investing its excess cash, or not realising the sales proceeds.
- Similarly having net working capital less than 25% of total current asset indicate lighter liquidity.
- Companies can forecast what their working capital will look like in the future. By forecasting sales, manufacturing, and operations, a company can guess how each of those three elements will impact current assets and liabilities.
Limitations of Working Capital
Working capital can be very insightful to determine a company’s short-term health. However, there are some limitations to the calculation that make it misleading at time.
- Working capital is dynamic. If a company is fully operating, it’s likely that several current asset and current liability accounts will undergo change. Therefore, by the time financial information is accumulated, it’s likely that the working capital position of the company has already changed.
- Working capital fails to consider the specific types of underlying accounts. For example, if a company has high current assets in the form of accounts receivable, it will still show positive working capital. However, its financial health depends on whether its customers will pay and whether the receivable will convert to cash.
- On a similar note, assets can quickly become devalued. The raw material or finished goods price may drop. The accounts receivable balances may lose value if a top customer face financial crisis. Therefore, a company’s working capital may change simply based on forces outside of its control.
- This can play other way too with rise in raw material and finished good price, sudden realisation of old receivable etc.
- There could be unknown debt obligations by way of statutory payment, default to banks etc. It will impact working capital of the company.
Managing Working Capital
A company can manage its working capital by understanding the process cycle, revenue realisation cycle and available credit in the market. There are many management method formulated by management gurus. They all revolve around 5 aspects 1) Liquidity management, 2) Account receivable management, 3) Inventory management, 4) Account payable management and 5) Short-term debt management.
Once the company understand its process cycle, it can plan accordingly how much stock to hold, where to source and at what price. Such arrangement will help the company to get raw material supply on continuous basis without holding unnecessary stocks.
Similarly, the distribution channel analysis help the company to manage its receivables. The company may require forego little money to realise receivable on time. But that improves its liquidity.
A company can also improve working capital by reducing its short-term debts. The company can avoid taking on debt when unnecessary or expensive, and the company can strive to get the best credit terms available. The company can be careful of spending both externally to vendors and internally with resources they have on hand. At no point company should utilise Term Loan or long term debt for working capital purpose.
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