Ever heard the term “networking capital”, but you didn’t know what it means? If that’s the case, this article comes to your aid.
The net working capital is a calculation that estimates the ability of a company to pay off its current liabilities with existent assets. It’s a very important measurement and it’s used by general creditors, vendors, and management. Through the equation, they can find out about the management’s ability to efficiently use its assets, as well as the company’s short-term liquidity.
The formula focuses on liabilities such as accounts payable, trade debts and vendor notes, as they need to be repaid the same year. The creditors and vendors want to see whether current assets are able to pay for the liabilities for the upcoming 12 months. If the firm can’t pay, then it will have to use the long-term assets. Want to find more about the net working capital? Read the following paragraphs for a better insight.
Analyzing New Working Capital
The New Working Capital can either be positive or negative. So, let’s start with the good one. The positive one is, as expected, the preferred option. It can show investors and creditors that the firm has the ability to generate enough from operations to repay the present obligations with current assets. Moreover, it shows that the company has enough funds to expand quickly without taking any new investors. A negative one, on the other hand, reveals that the company’s operations are not producing enough to support the debts. If this continues, then the firm may have to sell some of the long-term income-producing assets in order to pay for present obligations such as payroll and AP. The firm would have to take on new investors on debt to expand, and it has the risk of leading it to bankruptcy.
What is the formula?
The net working capital has a specific formula to be calculated. Basically, it subtracts the current liabilities from the assets. So, the equation looks like this:
The current assets in the formula include accounts receivable, cash, short-term investments, and inventory. The current liabilities usually include accrued expenses and taxes, accounts payable, customer deposits and other trade debt.
How does the Net Working Capital Change?
Just because the net working capital is negative, that doesn’t mean it will stay like that forever. There are three ways in which it can be improved over the year.For instance, the firm can reduce the amount of carrying inventory by sending back the goods that are unmarketable to the suppliers. Another way would be decreasing the company’s accounts receivable collection time. The third way would be negotiating with suppliers and vendors for longer accounts payable terms of payment.
By conducting any of these actions, the net working capital can improve and become positive.To conclude, the net working capital is a liquidity calculation, and it reveals whether a firm is able to repay the current liabilities using the current assets. Hopefully, you are now more familiar with the term.