Working capital may be defined as a financial metric which relates to business oriented operating liquidity. It can be available for organizations, individuals and government entities. The calculation of the net working capital is expressed in the following formula:
Current assets – Current liabilities = Net working capital
Current assets is defined as assets that are available to a firm within the next 12 months.
Current liabilities are those that are due within the next 12 months.
Net working capital shows the liquidity of the company, which means that it indicates the financing needs of a company, both through long-term and short-term financing sources. In general, it indicates the short-term financial condition of a company.
Types of Net working capital
There are two types of net working capital – positive and negative.
Positive net working capital is defined when current assets exceed current liabilities.
Negative net working capital takes place when current liabilities are higher current assets.
Importance in the business
When the formula Current Assets – Current Liabilities = Working Capital is applied, the result can be both: positive or negative. If the result of the equation is vastly positive, it means that the short-term funds available from current assets will be enough to cover the current liabilities as they come for the payment. On the other hand, if the result of the equation is vastly negative, the business may not be have enough funds to cover its payments for the current liabilities, so there is a possibility of bankruptcy.
Using net working capital in determining the company’s growth
Net working capital may be useful when trying to assess the ability of a firm to grow fast. If the company has substantial cash reserves, the chances for it to rapidly grow are better since there is more cash which can be used to expand the business. Tight working capital means that the company is not in the situation to spend money on its growth. The ability of a firm to grow can be indicated if the terms for accounts receivables are shorter then for accounts payable. It is a lot better if a firm is able to gather cash from its customers before the suppliers and other work related expenses need to be paid.
Ways to alter net working capital
Giving customers shorter time period in which they need to pay for the company’s products/services.
Collecting more actively outstanding accounts receivable.
Reducing inventory investment.
Bringing back to suppliers unused assets and getting a restocking fee.
Prolonging the time period for accounts payable to be covered.