Investment Analysis

Incremental Net Working Capital (NWC)

Step-by-Step Guide to Understanding Incremental Net Working Capital (NWC)

Last Updated February 20, 2024

What is Incremental Net Working Capital?

The Incremental Net Working Capital (NWC) measures the percent change in a company’s operating current assets and current liabilities relative to its change in revenue.

Table of Contents

How to Calculate Incremental Net Working Capital
Incremental Net Working Capital Formula (NWC)
How to Interpret Change in NWC?
Incremental Net Working Capital Calculator (NWC)
1. Operating Assumptions
2. Change in Net Working Capital (NWC) Calculation Example
3. Incremental Net Working Capital Calculation Example (NWC)

How to Calculate Incremental Net Working Capital

The incremental net working capital (NWC) is the ratio between the change in a company’s net working capital (NWC) and the change in revenue in the coinciding period, expressed as a percentage.

The incremental net working capital (NWC) rate answers the question of, “How much of a company’s net revenue is tied up in its operating working capital to generate a dollar of revenue?”

Conceptually, an investment in net working capital (NWC) is a core value driver that contributes toward shareholder value creation.

Therefore, the efficient allocation of capital toward net working capital (NWC) increases the free cash flow (FCF) generated by a company – all else being equal.

Historical Working Capital Needs → In practice, the main use-case of the incremental net working capital (NWC) rate is to develop an understanding of a company’s historical working capital needs.
Projection of Working Capital Spending Requirements → Based on the insights derived from analyzing historical data and the trends in recent trajectory, the incremental net working capital as a percentage of incremental revenue can be an operating driver underpinning the pro forma forecast.

The net working capital (NWC) metric – the difference between a company’s operating current assets and operating current liabilities – is a measure of a company’s near-term liquidity and capacity to meet its short-term obligations.

The process to calculate the incremental change in net working capital (NWC) is a six-step process:

Calculate Operating Current Assets and Operating Current Liabilities in the Current Period
Calculate Operating Current Assets and Operating Current Liabilities in the Prior Period
Determine the Net Working Capital (NWC) for the Current and Prior Period
Calculate the Change in Net Working Capital (NWC)
Divide the Change in Net Working Capital (NWC) by the Change in Revenue (Current Period Minus Prior Period)
Convert the Incremental Change in NWC into Percentage Form by Multiplying by 100

Incremental Net Working Capital Formula (NWC)

The formula to calculate the incremental change in net working capital (NWC) divides the change in net working capital (NWC) by the change in revenue.

Incremental Net Working Capital (%) = Change in Net Working Capital (NWC) ÷ Change in Revenue

Where:

Net Working Capital (NWC) = Operating Current Assets – Operating Current Liabilities.
Change in Net Working Capital (NWC) = Beginning Net Working Capital (NWC) – Ending Net Working Capital (NWC)
Change in Net Revenue = Ending Net Revenue – Beginning Net Revenue

So, why does the change in net working capital (NWC) formula subtract the ending NWC balance from the beginning NWC balance?

In short, measuring the change in NWC by deducting the ending period balance from the beginning period balance tends to be more intuitive in terms of understanding the impact on cash (i.e. “inflow” or “outflow”).

If a company’s change in NWC increased year-over-year (YoY), a negative sign is placed in front to reflect that the company’s free cash flow (FCF) is reduced because more cash is tied up in operations.

Note: Consistency throughout the entire model is the priority when it comes to sign convention in financial modeling.

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How to Interpret Change in NWC?

Briefly, an increase in net working capital (NWC) is an outflow of cash, while a decrease in net working capital (NWC) is an inflow of cash.

Why? The incremental increase in net working capital (NWC) implies more cash is tied up in operations, reducing the free cash flow (FCF) of a particular company.

Operating Current Asset → If an operating current asset, such as accounts receivable (A/R), increases, the change represents an “outflow” of cash, since the current balance of credit purchases still uncollected by the company in cash payment increased.
Operating Current Liability → If an operating current liability, such as accounts payable (A/P), increases, the change reflects an “inflow” of cash, because the balance of unmet invoices to suppliers and vendors increased, i.e. the company has not yet paid for the delivered order and retains possession of the cash.

The general rules of thumb to interpret the change in operating current assets and current liabilities are as follows.

Increase in Operating Current Asset → Cash “Outflow”
Decrease in Operating Current Asset → Cash “Inflow”
Increase in Operating Current Liability → Cash “Inflow”
Decrease in Operating Current Liability → Cash “Outflow”

Incremental Net Working Capital Calculator (NWC)

We’ll now move to a modeling exercise, which you can access by filling out the form below.

1. Operating Assumptions

Suppose we’re tasked with calculating the incremental net working capital (NWC) of a company, given the following historical data.

Selected Financial Data	Year 0	Year 1	Year 2	Year 3	Year 4
Net Revenue	$200 million	$210 million	$220 million	$230 million	$240 million
Accounts Receivable (A/R)	$40 million	$46 million	$52 million	$58 million	$64 million
Inventory	$20 million	$22 million	$24 million	$26 million	$28 million
Current Operating Assets	$60 million	$68 million	$76 million	$84 million	$92 million
Accounts Payable (A/P)	$30 million	$35 million	$40 million	$45 million	$50 million
Accrued Expenses	$10 million	$11 million	$12 million	$13 million	$14 million
Current Operating Liabilities	$40 million	$46 million	$52 million	$58 million	$64 million

Since the total operating current assets and operating current liabilities were provided, the next step is to calculate the net working capital (NWC) for each period.

The net working capital (NWC) is the difference between the total operating current assets and operating current liabilities.

Net Working Capital (NWC), Year 0 = ($20 million)
Net Working Capital (NWC), Year 1 = ($22 million)
Net Working Capital (NWC), Year 2 = ($24 million)
Net Working Capital (NWC), Year 3 = ($26 million)
Net Working Capital (NWC), Year 4 = ($28 million)

Based on the computed NWC figures, the current operating liabilities of the company exceed the current operating assets.

Practical Application – Net Working Capital (NWC)

The net working capital (NWC) metric is different from the traditional working capital metric, because non-operating current assets and current liabilities are excluded in the calculation.

Cash and Cash Equivalents → The net working capital (NWC) metric must omit cash and cash equivalents, such as marketable securities and short-term investments.
Short-Term Debt and Interest-Bearing Securities → The net working capital (NWC) metric must exclude short-term borrowings, the portion of long-term debt due within twelve months (<12), and any interest-bearing securities.

Cash and cash equivalents are not part of the core operations of a company’s revenue model, and are closer to investing activities (i.e. interest income).

Similarly, debt and interest-bearing securities are also excluded in net working capital (NWC), because such instruments are closer to financing activities (i.e. interest expense).

Note: Certain practitioners include the minimum cash balance in the net working capital (NWC) metric, based on the notion that the company is required to retain some cash on hand to continue running its business.

2. Change in Net Working Capital (NWC) Calculation Example

In the next section, the change in net working capital (NWC) – i.e. the increase / (decrease) in net working capital (NWC) – will be determined.

The change in NWC is calculated by subtracting the current period NWC balance from the prior period NWC balance.

Change in NWC, Year 1 = $20 million – $22 million = ($2 million)
Change in NWC, Year 2 = = $24 million – $22 million = ($2 million)
Change in NWC, Year 3 = = $26 million – $24 million = ($2 million)
Change in NWC, Year 4 = = $28 million – $26 million = ($2 million)

The net working capital (NWC) of the company is increasing by $2 million each period.

The parenthesis enclosed around each figure indicates a negative value – which to reiterate from our earlier section on sign convention – signifies an “outflow” of cash.

3. Incremental Net Working Capital Calculation Example (NWC)

In the final part of our exercise, the incremental net working capital (NWC) will be calculated and expressed as a percentage.

The change in net revenue is the difference between the ending and beginning balance.

Net Revenue, Year 1 = $210 million – $200 million = $10 million
Net Revenue, Year 2 = $220 million – $210 million = $10 million
Net Revenue, Year 3 = $230 million – $220 million = $10 million
Net Revenue, Year 4 = $240 million – $230 million = $10 million

Given the step function used in our model, the formula to calculate the incremental NWC is constant.

Incremental Net Working Capital (NWC) = $2 million ÷ $10 million = 20.0%

Stated in gross terms, the incremental net working capital (NWC) is $10 million. However, the more practical method is to convert the figure into a percentage for forecasting (and comparability).

In conclusion, our hypothetical company’s incremental net working capital (NWC) rate implies that approximately 20% of its net revenue is tied up in its operations per dollar of incremental revenue.