Net working capital is a value calculated as the difference between current assets and short-term liabilities of a company.
Current assets are those assets of the company that the company plans to use over the next year – to turn into money (for example, sell) or into expenses (for example, write off to the cost price).
Working capital composition
The current assets include the following:
- short-term receivables;
- short-term financial investments;
- VAT on acquisitions;
- Other current assets.
Inventories are inventory items owned by a company. Inventories include, for example, raw materials and materials that the organization plans to process during the production process to obtain finished goods (finished goods are also included in the inventory). In addition, inventory can include tools, office equipment, utensils, office furniture, stationery, etc.
It should be emphasized that in the balance sheet inventories are shown net of impairment (provision for impairment of tangible assets). This impairment is relevant in cases where, due to some reason, stocks have become unusable and lost their value (damage, expiration, theft, fire, flooding, etc.).
Short-term accounts receivable are accounts receivable from counterparties to this organization, which are scheduled to be settled within a year. Examples of short-term receivables are customer receivables for products supplied or suppliers receivable for advances paid to them.
Short-term financial investments are funds placed in deposits, securities and other financial instruments that are planned to be withdrawn from these instruments to the company’s accounts during the year.
Purchase VAT is the VAT paid by an organization when purchasing goods, works or services. This VAT is a current asset, since it can be filed for reimbursement from the budget, or offset with VAT, which the company is obliged to pay from the proceeds received.
Other current assets include all current assets that are not reflected in any of the previous categories.
Other current assets include:
- VAT on advances received;
- overpaid amounts of taxes, in respect of which a decision on refund from the budget has not been made;
- the cost of spoiled inventories, for which a decision has not been made to write off to the cost price or to the persons guilty of spoiling;
- and etc.
The second part of net working capital is short-term liabilities, which are liabilities that must be settled in less than 12 months.
Short-term liabilities can be divided into the following categories:
- short-term loans and borrowings;
- short-term payables;
- reserves (estimated liabilities);
- other short-term liabilities.
Short-term loans and borrowings are funds borrowed from financial institutions (loans) or from other organizations and individuals (loans). This category of liabilities, along with long-term loans and borrowings, constitutes the company’s financial debt.
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Short-term payables are obligations to counterparties payable by this organization during the year.
Short-term payables can be classified as follows:
- accounts payable to suppliers (for the supplied materials, services rendered, work performed);
- accounts payable to buyers (for advances received from them);
- accounts payable to the budgetary system (taxes, fees, insurance premiums);
- accounts payable to personnel (wages);
- other accounts payable (to insurance, factoring companies, etc.).
Provisions are liabilities that meet the following criteria:
- as a result of past events, a certain obligation has arisen, the fulfillment of which cannot be avoided;
- the probability of the need to fulfill the obligation is assessed as high;
- the amount of the obligation can be estimated.
Examples of estimated liabilities are reserves for land reclamation (when environmentally harmful production is located on them) or reserves for the fulfillment of claims of plaintiffs for legal proceedings pending at the reporting date.
Other short-term liabilities include all short-term liabilities that are not reflected in any of the previous categories.
Having considered the content of current assets and short-term liabilities, we proceed to the analysis of net working capital.
If the working capital as such is called the current assets of the organization, then the net working capital (NWC, net working capital) is the difference between the working capital and the short-term liabilities of the company. This is due to the fact that current assets, as a rule, are financed by short-term liabilities, and that part of the current assets that remains with the enterprise after their redemption remains “net”, that is, free from short-term liabilities.
Net working capital is one of the most important indicators of the quality of financial management in a company. If the net working capital is negative or close to zero, it can be concluded that the organization is too heavily indebted in the short term, as well as the threat of its solvency and low liquidity of assets . At the same time, there are industries for which negative net working capital is the norm: for example, in fast food restaurants NWC <0 does not indicate any crisis phenomena, since the operating cycle of such enterprises (turning stocks into money) is extremely short.
On the other hand, the constant growth of net working capital in dynamics may also indicate negative trends, in particular, the ineffective financial management of the organization. Thus, the growth of NWC may be a consequence of the progressing “work to the warehouse”, when the inventory balances in the company’s warehouses grow at a faster pace than the cost price, reducing the inventory turnover , which can lead to overstocking and an increase in warehouse space costs. In addition, this phenomenon may indicate an increase in accounts receivable due to the emergence / increase in problems with its payment by counterparties.
Net working capital also plays a significant role in business valuation, when the change in NWC becomes one of the terms in calculating the organization’s free cash flow. A positive change (growth) in net working capital indicates an outflow of funds in favor of the purchase of assets that make up the NWC, or in favor of the repayment of short-term liabilities. In turn, the decline in NWC indicates the release of cash from working capital, which leads to an increase in free cash flow.
An example of calculating net working capital
Consider the calculation of the company’s net working capital based on the following reporting forms:
Current assets: 400 + 400 + 100 + 100 = 1,000
Short-term liabilities: 300 + 200 = 500
NWC = 1,000 – 500 = 500
Thus, the net working capital is an integral indicator that demonstrates the ratio between current assets and short-term liabilities of the organization. At the same time, the change in net working capital in dynamics testifies, as a rule, to a change in the approach of the organization’s management to financing the company’s current assets.