Net working capital = current assets – current liabilities
Net working capital is also known as working capital, the formula for net working capital is utilized by analysts and investors to calculate the remaining liquid assets of a company after subtracting current liabilities.
If you are new to accounting terms then you must like to understand that current assets are those assets which are available within 12 months. While on the other side current liabilities are those liabilities which are due within 12 months.
How net working capital formula is useful for investors
Net working capital is basically used to assess the cash flows of a company in a mix of other financial indicators. Like net working capital is most commonly used with free cash flow to equity formula and sometimes also with free cash flow to firm formula.
In the formula for free cash flow to equity, the change in net working capital is determined. An increase in net working capital indicates that cash will not be available for equity and vice versa. In simple words, it shows that capital requirement is increased for company operations and money will not be available as equity.
It can be seen easily, that net working capital formula uses the same variables as those used in current ratio. But the approach of using things differ in both formulas, although both are referred as liquidity ratios and used to measure ability of a company to meet its current liabilities.
However, if net working capital is significantly positive, then it is considered as a sign that short-term funds are more than enough to handle business current liabilities. On the other side if the calculations show that figures are substantially negative then the business may be at a risk of insolvency.
To get a better depth it is advised to track a more long trend line lets say for 5-years to investigate decline or improvements in net working capital over the selected time period.
What other factors can influence Net Working Capital
- Line of Credit: Net working capital does not take in to account any available line of credit. A business can meet the shortfall of cash flows by using this option while keeping the business running. On the other side, line of credit may be already had been used to fulfill obligations and may be not available for coming insolvency.
- Current Assets: The formula assumes that all current assets will be readily available for paying current liabilities. While in reality this may not be a case where one can face any difficulties to covert the assets in to cash including inventories and receivables. The size of customers can also influence the payment time as big customers can easily influence things with negotiating powers to deliberately delay the payments.