As per studies, lack of working capital in a business resulted in less investment in the technology, difficulty in expanding into new markets, less salary and wage payment, etc. To reduce this, every business owner has to know what working capital is and its importance in the day-to-day working of their organization.
What is Working Capital?
Working capital or net-working capital is the measurement of the short-term financial health of a business. It is the best tool to understand whether a company is in a good position or not. It indicates the ability of a company to pay all its debts using cash or cash equivalents.
Net-working capital is a financial metric that helps to plan the future needs of a company. It is the lifeline of a business that helps it to run smoothly and carry out its day-to-day operations. It measures the liquidity and operational efficiency of a company.
A business that maintains a positive working capital is likely to have a better ability to withstand financial challenges. These businesses will have enough current assets to pay off their debts for the next twelve months and some money left to invest. This is a sign of the financial strength of a company.
While negative working capital is when a company’s current liabilities exceed its current assets. It states that the business owes debts more than the cash it holds. This is a signal that the cash flow needs to be increased.
Understanding the Components of Net Working Capital
Frequently the interrelationships between the components of net-working capital create a real-time challenge. Inventory Working capital is calculated by subtracting the company’s current liabilities from its current assets. Therefore, it mainly has two components. They are current assets and current liabilities.
Now you might probably be wondering what current assets and current liabilities are. Here are their explanations:
Current Assets
Current assets are those assets that a company owns currently. It can be tangible or intangible. These assets can be turned into cash quickly i.e. within one year or one business cycle, whichever is earlier. In short, current assets are all those assets that a company expects to sell or use as a result of standard business operations over the coming year.
Current Liabilities
Current liabilities are the short-term monetary obligations that a company has to pay off within one year or one business cycle, whichever is earlier. Liabilities occur when a company has undergone a transaction that has an expected future cash outflow or other economic resources. It refers to all debts and expenses that a company owes currently.
How to Calculate Net Working Capital?
The calculation of net-working capital is simple and all the information needed for its calculation can be found in the balance sheet. Working capital is calculated by subtracting all current liabilities from the total current assets. The formula may be as stated below:
Why is Net Working Capital Important?
Net-working capital is used to fund operations and meet the short-term obligations of a company. A business can make payments to its employees and suppliers, and meet other financial obligations only if it has enough working capital. It can also be used to fund further growth of the organization without incurring debt.
Demonstrating a positive net-working capital can help a company to qualify itself for loans or other forms of credit. By effectively maintaining working capital a company can free up its cash that would otherwise be trapped on its balance sheets.
Companies need to have enough cash available to cover both expected and unexpected costs, along with making the best use of available funds. This can be achieved by effective management of accounts payable, accounts receivable, inventory, and cash in hand.
Net Working Capital Examples
Example 1: Following is the balance sheet of The Coca-Cola Company for the year ending 31st December 2020 and 2019.
Net working capital is calculated as:
Net Working Capital = Total Current Assets - Total Current Liabilities
For the year ending 31st December 2020
- Total current assets = 19240
- Total current liabilities = 15990
- Therefore, Working Capital = 19240 - 15990 = 3250
For the year ending 31st December 2019
- Total current assets = 20411
- Total current liabilities = 15299
- Therefore, Working Capital = 20411 - 15299 = 5112
From the above calculations, it is clear that for both the accounting years The Coca-Cola Company had a positive net-working capital. The company had a decent amount of current assets left after paying off all its current obligations. This means that the company has good working capital management and is in a better financial position.
Example 2: The following are the current assets and liabilities of Shriram EPC Ltd. for the accounting years March 2021 and March 2020.
Net working capital is calculated as:
Net Working Capital = Total Current Assets - Total Current Liabilitie
For the year ending March 2021
- Total current assets = 1346.30
- Total current liabilities = 978.18
- Therefore, Working Capital = 1346.30 - 978.18 = 368.12
For the year ending March 2020
- Total current assets = 1480.60
- Total current liabilities = 842.25
- Therefore, Working Capital = 1480.60 - 842.2 = 638.35
As per the above example of Shriram EPC Ltd. has a positive net-working capital for both the accounting years. The company has a decent amount of working capital left for further growth even after paying off current obligations.
Example 3: Below is the current assets and current liabilities of Sintex Industries Ltd. for the accounting years 2021 and 2020.
Net working capital is calculated as:
Net Working Capital = Total Current Assets - Total Current Liabilities
For the year ending March 2021
- Total current assets = 1075.51
- Total current liabilities = 7988.32
- Therefore, Working Capital = 1075.51 - 7988.32 = (6912.81)
For the year ending March 2020
- Total current assets = 995.54
- Total current liabilities = 7400.28
- Therefore, Working Capital = 995.54 - 7400.28 = (6404.74)
From the above calculation of net-working capital, it is clear that Sintex Industries Ltd. has a negative figure for both the accounting years. This means that the company does not even have the required amount of current assets to pay off its current liabilities.
Key Takeaways
Net-working capital refers to the difference between a company’s short-term assets and short-term liabilities. It is used to measure the short-term financial health, liquidity, and operational efficiency of a company.
If the net-working capital is substantially positive, it indicates that the funds available from the current assets are more than adequate to pay current liabilities and debts. If the net-working capital is negative, then the business will not be having sufficient funds to pay off the current liabilities. A company with negative working capital may be in danger of bankruptcy.
The two main components of net-working capital are:
- Current Assets
- Cash in hand
- Accounts receivable
- Stock inventory
- Marketable securities
- Pre-paid liabilities
- Other liquid assets
- Current Liabilities
- Accounts payable
- Short-term loans
- Dividends
- Bank overdrafts
- Accrued expenses
- Tax payable
Net-working capital can be calculated as follows:
Net Working Capital = Current Assets - Current Liabilities
The importance of net-working capital are:
- Helps in Management of Liquidity
- Helps in Making Effective Decision
- It is an Addition to the Value of Business
- Helps During the Time of Cash Crunches
- Strengthens Work Culture of the Business
- Helps in Earning Short-Term Profits
- Plans Perfect Investments
To conclude, I would like to say that every company needs to manage its net-working capital optimally. This will help the organization to invest the excess working capital if any in its growth. Working capital management is a strategy that requires monitoring a company’s current assets and current liabilities to ensure its efficient functioning.
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Deskera Content Team
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