What is Change in Net Working Capital?
The Change in Net Working Capital (NWC) section of the cash flow statement tracks the net change in operating assets and operating liabilities across a specified period.
If the change in NWC is positive, the company collects and holds onto cash earlier. However, if the change in NWC is negative, the business model of the company might require spending cash before it can sell and deliver its products or services.
How to Calculate Net Working Capital (NWC)?
As a general rule, the more current assets a company has on its balance sheet in relation to its current liabilities, the lower its liquidity risk (and the better off it’ll be).
- Current Liabilities: Obligations that a company is required to pay off (outflow) within the year – e.g. accounts payable, accrued expenses
- Current Assets: Resources that can be readily liquidated and converted into cash (inflow) or are expected to be used within the year – e.g. accounts receivable, inventory
While certain accounting textbooks will define the change in net working capital as current assets minus current liabilities, the more practical formula excludes cash and short-term investments like marketable securities and commercial paper, as well as any interest-bearing debt such as loans and bonds.
- Operating Current Assets → Accounts Receivables (A/R), Inventory, Prepaid Expenses
- Operating Current Liabilities → Accounts Payable (A/P), Accrued Expense
The reason is that cash and debt are both non-operational and do not directly generate revenue.
In fact, cash and cash equivalents are more related to investing activities because the company could benefit from interest income, while debt and debt-like instruments would fall into the financing activities.
Change in Net Working Capital Formula (NWC)
Since we have defined net working capital, we can now explain the importance of understanding the changes in net working capital (NWC).
On the cash flow statement, the changes in NWC are essential because tracking these changes over time (e.g. year-over-year or quarter-over-quarter) helps assess the degree to which a company’s free cash flows are going to deviate from its accrual-based net income (“bottom line”).
The formula for the change in net working capital (NWC) subtracts the current period NWC balance from the prior period NWC balance.
As a sanity check, you should confirm that if the NWC is growing year-over-year, the change should be reflected as a negative (cash outflow), and the change would be positive (cash inflow) if the NWC is declining year-over-year.
How to Find Change in Working Capital on Cash Flow Statement (CFS)?
The screenshot below is of Apple’s cash flow statement, where the highlighted rows capture the change in Apple’s working capital assets and working capital liabilities.
Screenshot from Apple 3-Statement Model (Source: WSP Premium Package)
What is a Good Change in Net Working Capital (NWC)?
But if the change in NWC is negative, the net effect from the two negative signs is that the amount is added to the cash flow amount.
- Increase in NWC → Less Free Cash Flows (FCFs)
- Decrease in NWC → More Free Cash Flows (FCFs)
For instance, let’s say that a company’s accounts receivables (A/R) balance has increased YoY while its accounts payable (A/P) balance has increased as well under the same time span.
The net effect is that more customers have paid using credit as the form of payment, rather than cash, which reduces the liquidity (i.e. cash on hand) of the company.
As for payables, the increase was likely caused by delayed payments to suppliers. Even though the payments will someday be required to be issued, the cash is in the possession of the company for the time being, which increases its liquidity.
How to Interpret Negative Net Working Capital (NWC)?
In the absence of further contextual details, negative net working capital (NWC) is not necessarily a concerning sign about the financial health of a company.
For instance, if NWC is negative due to the efficient collection of receivables from customers that paid on credit, quick inventory turnover, or the delay of supplier/vendor payments, that could be a positive sign.
However, negative working capital could also be a sign of worsening liquidity caused by the mismanagement of cash (e.g. upcoming supplier payments, inability to collect credit purchases, slow inventory turnover). In such circumstances, the company is in a troubling situation related to its working capital.
Change in Net Working Capital Calculator (NWC)
We’ll now move to a modeling exercise, which you can access by filling out the form below.
1. Balance Sheet Assumptions
In our hypothetical scenario, we’re looking at a company with the following balance sheet data (Year 0).
Financial Assumptions (Year 0)
- Accounts Receivable (A/R) = $50mm
- Inventory = $25mm
- Accounts Payable = $40mm
- Accrued Expenses = $20mm
Given those figures, we can calculate the net working capital (NWC) for Year 0 as $15mm.
- Current Operating Assets = $50mm A/R + $25mm Inventory = $75mm
- (–) Current Operating Liabilities = $40mm A/P + $20mm Accrued Expenses = $60mm
- Net Working Capital (NWC) = $75mm – $60mm = $15mm
As for the rest of the forecast, we’ll be using the following assumptions for each projected year:
- Accounts Receivable (A/R) = (+) $10mm Growth YoY
- Inventory = (+) $5mm Growth YoY
- Accounts Payable = (+) $20mm Growth YoY
- Accrued Expenses = (+) $10mm Growth YoY
2. Change in Net Working Capital Calculation Example (NWC)
Once the remaining years are populated with the stated numbers, we can calculate the change in NWC across the entire forecast.
Since the growth in operating liabilities is outpacing the growth in operating assets, we’d reasonably expect the change in NWC to be positive.
The change in NWC comes out to a positive $15mm YoY, which means that the company is retaining more cash within its operations each year.
- Change in Net Working Capital (NWC) = +$15 million
The illustrated rule here affirms that increases in operating current assets are cash outflows, while increases in operating current liabilities are cash inflows.