Net Working Capital (NWC), or just ‘working capital’ as it is often referred to in practice, is a measure of operating liquidity. It provides a rough indication of a company’s ability to pay back its short-term creditors with those funds which are immediately available.
Working capital is calculated with the below formula, with ‘Current Assets’ denoting those assets which can reasonably be expected to convert to cash within the year, and ‘Current Liabilities’ those debts which must be paid within the same time period.
Working Capital = Current assets – Current Liabilities
So, with an understanding of how working capital is calculated, what does it actually mean? Well, if a company’s net working capital is positive, this is usually a good thing. It indicates that the company should have enough short-term funds to meet its current liabilities, and a little more. Net Working Capital also gives a rough idea as to how fast a business can grow. Naturally, if a business has excess cash after it has met its liabilities, then it can reinvest to grow organically. If, on the other hand, it is substantially negative, then in many cases there is cause for concern. In this situation, the business may struggle to meet its short-term debt obligations and run the risk of bankruptcy.
Working capital is used extensively in cash flow analyses. In a discounted cashflow (DCF) model for example, we could calculate free cash flow to equity as follows:
+ Depreciation & Amortization
+ Proceeds from New Debt Issues
- Preferred dividends
- Capital Expenditures
- Changes in Non-cash Net Working Capital (Working Capital Needs)
- Principal Repayments
However, it’s worth bearing in mind that Net Working Capital can sometimes be a misleading metric:
• Sometimes, a business may pay for its short-term obligations with a line of credit, which the net working capital calculation does not take into account.
• Current assets are not always as liquid as they are made out in net working capital calculations. For example, current inventory is often listed as worth more on the balance sheet than it can actually be sold for in bad market conditions.
• Because it is measured as of a specific date on the balance sheet, anomalies in figures may occasionally crop up.
This is not to mention the fact that, in some situations, negative working capital can actually be a sign of good management and capital allocation. Some companies, for example McDonalds and Amazon, generate cash so quickly that their net working capital can be sustainably negative. In these cases, transactions build up so rapidly that the business has no problem in raising cash to pay their creditors. In fact, the business will often have sold the product before they have even paid for it themselves!
Confused? Remember that on a balance sheet, inventory is always valued at the lower figure of cost price and market value. In Amazon’s case, this means the wholesale price they paid for a product is what is used by their accountants. This therefore cannot account for the profit margins Amazon will benefit from in selling the good. Thus, for particularly fast-moving businesses, negative net working capital indicates that the business is being run efficiently.
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