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Net Working Capital (NWC)

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

Last Updated December 31, 2023

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Net Working Capital (NWC)

How to Calculate Net Working Capital?

NWC stands for “net working capital” and is a financial metric used to evaluate a company’s near-term liquidity risk.

The net working capital (NWC) metric is the ratio between a company’s operating current assets and operating current liabilities.

  • Operating Current Assets → The short-term assets belonging to a company that can be converted into cash within the next twelve months (i.e. “cash inflow”)
  • Operating Current Liabilities → The short-term liabilities of a company represent the obligations coming due within the next twelve months (i.e. “cash outflow”)

A company with more operating current assets than operating current liabilities is considered to be in a more favorable financial state from a liquidity standpoint, where near-term insolvency is unlikely to occur.

The most common examples of operating current assets include accounts receivable (A/R), inventory, and prepaid expenses.

On the other hand, examples of operating current liabilities include obligations due within one year, such as accounts payable (A/P) and accrued expenses (e.g. accrued wages).

  • Positive Net Working Capital (NWC) → If the ratio of current operating assets to current liabilities is 1.0 or higher, the net working capital (NWC) is positive. Hypothetically, the company can sufficiently pay off its short-term obligations by liquidating its current operating assets, if necessary.
  • Negative Net Working Capital (NWC) → The company’s short-term liabilities exceed the value of the company’s current assets, which signals that external financing might urgently be required.

In particular, creditors such as bank lenders pay close attention to a company’s net working capital (NWC) to understand the borrower’s creditworthiness and borrowing capacity, i.e. quantify the risk of providing debt financing to the company.

Aside from gauging a company’s liquidity, the NWC metric can also provide insights into the efficiency at which operations are managed, such as ensuring short-term liabilities are kept to a reasonable level.

Net Working Capital Formula (NWC)

The net working capital (NWC) formula is as follows.

Net Working Capital Formula (NWC) = Operating Current Assets Operating Current Liabilities

To reiterate, a positive NWC value is perceived favorably, whereas a negative NWC presents a potential risk of near-term insolvency.

The NWC metric is often calculated to determine the effect that a company’s operations had on its free cash flow (FCF).

Since we’re measuring the increase (or decrease) in free cash flow, i.e. across two periods, the “Change in Net Working Capital” is the right metric to calculate here.

Change in Net Working Capital (NWC) = Prior Period NWC Current Period NWC

The rationale for subtracting the current period NWC from the prior period NWC, instead of the other way around, is to understand the impact on free cash flow (FCF) in the given period.

An increase in an operating current asset (e.g. accounts receivable) from one period to the next represents a “use” of cash, while an increase in an operating current liability (e.g. accounts payable) is a “source” of cash (and vice versa).

With that in mind, the change in NWC is interpreted using the following rules:

  • Negative Change in NWC → More Free Cash Flow (FCF)
  • Positive Change in NWC → Less Free Cash Flow (FCF)

Net Working Capital (NWC) vs. Working Capital: What is the Difference?

The textbook definition of working capital is defined as current assets minus current liabilities.

However, the more practical metric is net working capital (NWC), which excludes any non-operating current assets and non-operating current liabilities.

  • Non-Operating Current Assets → Cash and cash equivalents, such as marketable securities, must be excluded in the net working capital (NWC) calculation. Unlike a current asset like accounts receivable—the uncollected cash proceeds from credit sales—cash itself and short-term investments are not directly a part of a company’s core operations. Rather, those two items are closer to investing activities, given that interest income can be earned.
  • Non-Operating Current Liabilities → Similarly, debt and any interest-bearing securities with debt-like features should be removed from any NWC calculation under the same logic. Contrary to a current liability, such as accounts payable—the unmet payment obligations to suppliers and vendors—debt is a source of financing (and not directly related to a company’s operations).

The interpretation of either working capital or net working capital is nearly identical, as a positive (and higher) value implies the company is financially stable, all else being equal.

The distinction is that net working capital (NWC) focuses on a company’s operational efficiency and the impact on free cash flow (FCF).

Net Working Capital Calculator (NWC)

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

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1. Balance Sheet Assumptions

Suppose we’re tasked with calculating the net working capital (NWC) of a company with the following balance sheet data.

Selected Balance Sheet Data
($ in millions) Year 0 Year 1 Year 2
Accounts Receivable (A/R) $40 $44 $48
Inventory 10 12 14
Current Operating Assets $50 $56 $62
Accounts Payable (A/P) $30 $35 $40
Accrued Expense 10 13 16
Current Operating Liabilities $40 $48 $56

2. Net Working Capital Calculation Example (NWC)

Since a company’s net working capital (NWC) is the difference between its operating current assets and operating current liabilities, we can subtract the two in each period to arrive at the following NWC values:

  • Year 0 = $50 million – $40 million = $10 million
  • Year 1 = $56 million – $48 million = $8 million
  • Year 2 = $62 million – $56 million = $6 million

From Year 0 to Year 2, the company’s NWC reduced from $10 million to $6 million, reflecting less liquidity (and more credit risk).

3. Change in NWC Calculation Example

In the final part of our exercise, we’ll calculate how the company’s net working capital (NWC) impacted its free cash flow (FCF), which is determined by the change in NWC.

  • Change in NWC, Year 0 to Year 1 = $10 million – $8 million = $2 million
  • Change in NWC, Year 1 to Year 2 = $8 million – $6 million = $2 million

Therefore, the impact on the company’s free cash flow (FCF) is +$2 million across both periods.

The issue, however, is that an increasing accounts receivable balance implies the company’s cash collection processes might be inefficient, and a rising inventory balance means more inventory is piling up (and not sold).

While A/R and inventory are frequently considered to be highly liquid assets to creditors, uncollectible A/R will NOT be converted into cash. In addition, the liquidated value of inventory is specific to the situation, i.e. the collateral value can vary substantially.

The positive impact on free cash flow (FCF) stems from the growth in accounts payable and accrued expenses year over year (YoY), outpacing the growth in operating current assets.

Since the company is holding off on issuing payments, the increase in payables and accrued expenses tends to be perceived positively.

Until the payment is fulfilled, the cash remains in the possession of the company, hence the increase in liquidity. But it is important to note that those unmet payment obligations must eventually be settled, or else issues could soon emerge.

Net Working Capital Calculator (NWC)

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Hussam
February 22, 2024 6:16 am

Do we need to deduct Capital lease obligations also from current liabilities to get to operating current liability?

Brad Barlow
February 22, 2024 1:50 pm
Reply to  Hussam

Hi, Hussam,

Yes, technically capital lease liability would be considered more like short-term debt than an operating liability like accounts payable.

BB

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