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Net Working Capital

Jeff Jewell —  04/03/2013 — 9 Comments

Net Working Capital (NWC) is is the difference between Current Assets and Current Liabilities. It is technically not a ratio (since there is no division involved in its computation). Rather it is a simple financial metric that is closely related to the various liquidity ratios.

Alternate Names

Working Capital

Category

Liquidity Ratios

Interpretation

Higher = More Liquid = Less Risky

Too High = Inefficient Use of Resources = More Costly = Lower Returns

Preferred Formula

Net Working Capital 1

Both of the variables can be found on the Balance Sheet or the Statement of Financial Position.

 Alternate Formula

Net Working Capital 2

The alternate formula is frequently used when firms have interest bearing (or costly) Current Liabilities. This formula generally results in a larger value than the preferred formula. The resulting answer shows the amount of Current Assets that are financed with costly sources of funds.  This is very useful in certain situations.

Expressed

Net Working Capital is always expressed in monetary terms, so to show NWC in U.S. Dollars it would be  $157,000.

Example

Working Capital Example 1

Interpretation

There are three primary reasons for computing Net Working Capital (NWC):

  1. To measure the firm’s liquidity
  2. To compute Total Capital (NWC is a component of Total Capital)
  3. To give information about how the firm finances its Current Assets

Liquidity

NWC is computed using the same data as the Current Ratio (the most commonly used liquidity ratio), so it conveys the same information about liquidity.  However, since NWC is measured in total dollars it is more difficult to interpret – and thus usually less useful as a liquidity measure – than the Current Ratio.  The exception to this of course is when having a liquidity measure in dollar terms is helpful.  This may be the case when undertaking certain forecasting and financial planning activities.

In general the basic interpretation guidelines for the Current Ratio apply to NWC.  See our post on the Current Ratio for more information.

Since NWC is computed using the same data as the Current Ratio there must be a mathematical relationship between the two concepts.  Consider the three companies below:

Net Working Capital Example 2

Company A has Current Assets exactly equal to Current Liabilities.  This results in a Current Ratio of exactly 1.00 and NWC of exactly $0.  Company B has Current Assets greater than Current Liabilities.  This results in a Current Ratio greater than 1.00 and NWC greater than zero.  Company C has Current Assets less than Current Liabilities.  This results in a Current Ratio < 1.00 and NWC less than zero.

So we can draw three general conclusions about the relationship between the Current Ratio and NWC:

  1. If Current Ratio > 1.00 then NWC > $0
  2. If Current Ratio = 1.00 then NWC = $0
  3. If Current Ratio < 1.00 then NWC < $0

In general higher Current Ratios (and thus higher NWC) indicate greater liquidity and less risk, while lower Current Ratios and NWC indicate less liquidity and more risk.  See our post of the Current Ratio for more information.

As with all of the liquidity ratios there is a tradeoff between lower risk (greater safety) and lower returns (higher opportunity costs or less efficiency). See our post on Opportunity Costs and Liquidity Ratios for more information (link).

Total Capital

NWC is important because it is one of the major determinants of Total Capital.  Total Capital is derived by making a simple transformation to the Balance Sheet.

The Balance Sheet (or Statement of Financial Position) is governed by The Accounting Equation:

Total Assets = Total Liabilities + Total Equity

We can restate this concept as below:

Current Assets + Net Fixed Assets = Current Liabilities + Long-Term Liabilities + Total Equity

Subtracting Current Liabilities from both sides we arrive at:

Net Working Capital + Net Fixed Assets = Long-Term Liabilities + Total Equity

The equation above is commonly referred to as the Managerial Balance Sheet Identity.  The Managerial Balance Sheet does not “total” to Total Assets like the (normal) Balance Sheet.  The values on both sides of the equation are less than Total Assets since Current Liabilities have been subtracted from both sides.  Rather, this new identity describes Total Capital.

Invested Capital = Net Working Capital + Net Fixed Assets

Capital Employed = Long-Term Liabilities + Total Equity

Since the Managerial Balance Sheet must balance we can also state:

Invested Capital = Capital Employed

In practice it is common to use the term Total Capital as a synonym for both Invested Capital and Capital Employed.

The Total Capital concept is very important to the field of finance.  Key concepts in finance like value creation and cost of capital are directly linked to Total Capital.  All else equal lower Total Capital is preferred to higher Total Capital.  (All else equal is a very important assumption here.)  Given the same level of cash flow but lower Total Capital, the firm’s Return on Capital will increase, thus increasing the firm’s value.

Notice that the preference for low Total Capital implies a preference for low NWC as well.  As mentioned earlier NWC is also a liquidity measure, with higher NWC indicating greater liquidity.  Therefore we have a tradeoff in the management of NWC.  Lowering NWC reduces liquidity, but also shrinks the firm’s Total Capital and (all else equal) improves returns and value creation.

Financing Information

The fact that NWC is measured in dollars may be a disadvantage when interpreting it as a liquidity measure.  However it is an advantage when using NWC to make inferences about how the firm finances its Current Assets.

We know all assets on the left side of the Balance Sheet must be financed by a “source of funds” on the right side of the Balance Sheet. For the Balance Sheet as a whole Total Assets = Total Liabilities + Total Equity.  This relationship is a “constant” that must always hold true.  If we take this same concept and apply it to Current Assets we get:

Current Assets = Current Liabilities + Long-Term Sources that Fund Current Assets

Like the Balance Sheet equation, the Current Assets equation is a way to express a simple concept with some basic mathematics.  Just like the Balance Sheet equation, the Current Assets equation above must always hold true (note that Long-Term Sources that Fund Current Assets can be positive, negative or zero – the equation does not imply a value for this item).  The Current Assets equation is based on three fundamental facts:

  1. Current Assets must be financed with funds on the right of the Balance Sheet.
  2. Current Assets are funded in part with Current Liabilities.
  3. If there are not enough Current Liabilities to completely fund Current Assets then the remaining portion must be financed with Long-Term Sources.

If we subtract Current Liabilities from both sides of the equation above we get:

Net Working Capital = Long-Term Sources that Fund Current Assets

So one way to interpret NWC is that it tells us the dollar amount of Current Assets that cannot be funded with Current Liabilities.  Since Long-Term Sources of Funds will typically be more expensive than Current Liabilities higher NWC are typically more expensive to fund than lower NWC.

To illustrate consider a simple example.  Assume that two firms (ABC and XYZ) have identical current assets.  However the firms have quite different current liabilities.  Some data on the two firms appears in the table below.

Net Working Capital Example 3As we see in the data, ABC Corp is very liquid.  It has a high current ratio and a large, positive NWC.  However when viewed from a financing perspective the large NWC may actually be a drawback.  ABC has $1,500,000 in Current Assets that must be financed from (presumably expensive) long-term sources of funds.  On the other hand XYZ Corp has very poor liquidity.  It has a low Current Ratio and a negative NWC.  However, from a financing perspective the negative NWC may have benefits.  XYZ is able to completely fund its Current Assets from (presumably cheap) Current Liabilities.  In addition is has $1,000,000 of Current Liabilities “left over” that can be used to fund its Net Fixed Assets.

To be clear, in “normal” situations the firm will want a positive NWC.  Larger values do indicate greater liquidity and less risk.  However, it is important to realize that higher NWC is not “free.”  All assets – even Current Assets – must be financed.  NWC tells us the dollar amount of Current Assets that cannot be financed with Current Liabilities.

Jeff Jewell

Posts Google+

Professor at Lipscomb University, Principal at Prium Investment Management, Publisher of RatioProfessor.com.

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