When a financial analyst takes a close look at a corporation’s financial statements like the balance sheet and income statement, he or she is generally looking to break the information down into a series of data points that can be interpreted more easily. One of those data points is the idea of net working capital, which is a value that assesses how liquid a company is in short-term periods should the need to liquidate arise.
In this article, we are going to look at how you can calculate net working capital, what it really means for a business and investors, and we will look at how a company can seek to improve its net working capital over time.
Calculating Net Working Capital
Net working capital is derived in a very similar fashion to the “working capital ratio” (e.g. current assets divided by current liabilities), although it is slightly different. Since net working capital is expressed in a dollar amount, the formula for NWC is: Current Assets minus Current Liabilities = Net Working Capital (NWC).
Of course, for those who may not be too familiar with accounting, a current asset is a balance sheet item that can be converted to cash within a period of one year (although some current ratios require a shorter time period), and a current liability is a short-term debt that must be repaid within one year or less. Typically, current liabilities consist of things like accounts payable, short-term notes, or commercial paper.
What Net Working Capital Means for a Company
With all that said, it is always better for a company to have a higher net working capital, and it is almost critical that a company’s NWC be greater than zero dollars. The greater the NWC of a company, the more likely it is that said company will be able to pay off its short-term debts if they were all called for immediately.
Thus, as a company’s NWC approaches zero (or even goes beneath zero in horrible circumstances) that company will be viewed as more of a default risk by investors. Therefore, it may become harder for company management to raise new capital for capital projects if financial markets and their participants don’t place much faith in the financial health of that company.
What NWC Means for Investors
On the other side of the same coin, if a company has an incredibly high net working capital, ratings agencies may consider that company to pose less of a default risk, which could translate to better bond ratings and lower bond yields. This would make a company that has a high NWC a more reasonably safe place for an investor to park their money assuming ceteris paribis.
Also, and perhaps more importantly, a high NWC could be an indicator that a company is able to sustainably grow simply by using its own internal operations to generate increasing cash flows instead of having to tap financial markets in order to produce growth.
Typically, we call these kinds of companies “growth” companies since they are able to reinvest high levels of cash flow into their operations, and investors often find that their capital appreciates quickly when invested in these kinds of companies (although the ride can be a little volatile at times).
How a Company Can Improve Net Working Capital
Obviously, net working capital is not the only factor that determines whether a company is a “good” or a “bad” company. Still, company management should attempt to do everything within their power to improve this important indicator whenever they can. Some of the actions that company management could take include:
- Increasing Longevity of Debt
In many instances, companies can often convert many of their debt holdings from short-term to longer-term debt, thereby making themselves more stable over short-term periods. While this may increase the total cost of debt (since long-term debt yields are usually higher than short-term yields), it will serve to visibly improve the company’s short-term liquidity.
Generally speaking, companies view accounts receivable that have not been paid within 90 days as delinquent and some companies forego including these in their accounts receivable account since they don’t think they will recuperate these sales made on credit. However, hiring a good collections team can serve to accrue back some of these losses and improve a company’s cash position, thereby improving the NWC in turn.
- Increase Inventory Turnover Rate
The final, and most important, way that a company can improve its NWC is by improving its inventory turnover rate. Since the price of inventory is far less than the revenue received from selling that inventory to the market, selling inventory increases a company’s NWC through the cash account balancing that occurs. As a result, a company that can start to flip inventory quicker will receive an improved net working capital over the long haul.
Wrapping It All Up
By taking these steps, a company will simultaneously make itself appear less risky to debt ratings services like Moody’s and Fitch, and investors will probably become more interested in that company as it converts that NWC into a higher, more sustainable long-term growth rate.