Net Working Capital is a key part of the Equifax Financial Statement used by virtually all companies large and small to operate their day-to-day operations. The term “Net Working Capital” is most commonly used in the context of business finance, as it represents the difference between current assets and current liabilities. Networking Capital is essential for any business that wishes to survive a lean market and remain viable.
The best way to think about Networking Capital is to consider cash flow. Cash flow is the total amount of money coming in and going out. In a lean market, that may change due to seasonal variation, but in general the cash flow will be negative. Networking Capital allows business owners to better manage their cash flow, which can be both a positive and negative indicator. The best way to think of Networking Capital is to consider cash that is not required to run the business – this cash can be placed in an accounts receivable facility and is called Working Capital.
When talking about Networking Capital, one must remember that the term is synonymous with current assets. Current assets refer to those assets, which are current liabilities, that are being purchased under the business’s capital cycle. For example, if a retailer purchases stocks from a supplier, that purchase is being made with the assumption of repayment of that debt after some period of time. That debt is called a receivable. At the end of the receivable cycle, the retailer would have either paid the entire debt, or have drawn from current assets to pay off the outstanding balance. If the company is experiencing a net loss for that period of time, its stock may have lost a portion of its value and net working capital would need to be increased to pay off the outstanding balance.
Defined Net Working Capital refers to the operating funds available, as well as the net worth of the business, less the current assets it owns, when all of its liabilities and assets are taken into account. The operating funds or working capital ratio reflects the efficiency with which a company operates. If a company operates inefficiently, its net working capital ratios will always be lower than its assets because the operating budget is not being properly managed. A company’s capital structure should include an adequate level of working capital.
A company’s Net Working Capital, also known as NDC, is calculated by subtracting the gross billings, the gross sale items, accounts receivable, and the current assets. After taking into consideration the Net Working Capital Ratio, the net working capital is then calculated. The calculation of net working capital includes gross assets, current assets, liabilities, net current liabilities, and net long-term liabilities. The gross billings and accounts receivable represent the tangible assets and accounts receivable of the business respectively. The current assets and current liabilities are the liabilities of the business that are currently located in a physical location.
A company’s Net Working Capital Needs is basically the liquidity requirements for it in terms of cash or its equivalents. If the current assets are liquid and the net working capital is positive, the owner may have access to more cash than its liabilities and net working capital ratios indicate. Conversely, when a company experiences negative cash flow from operations, the net working capital ratio will typically be negative and may reflect a company’s inability to generate an adequate amount of cash to support operations. To better understand how net working capital may vary across the different operations in a business, a net working capital line of credit can be used.
Net working capital cycles are essential to the proper management of a company’s liquidity. Proper net working capital cycle planning allows a company to plan for the rate at which cash flows are generated as well as the length of time it takes for these funds to be repaid. This planning also allows the lender to determine which assets should be repaid first. Lenders may approve a company’s application for a cash line of credit based on the net worth of the business as reflected on the balance sheet as well as various other metrics. Net worth refers to the value of a business that does not include any identifiable intangibles such as goodwill or long-term investments. In addition, net worth is calculated based on the current value of the total assets of the company less the total liabilities.
Net working capital cycle analysis is also used to determine the appropriate target rates of interest that a company should charge to its accounts receivable and accounts payable. The purpose of this analysis is to ensure that the interest rate provided to a company is adequate to cover its costs while generating enough cash flow to satisfy its obligations. Also, the amount of the interest paid should be enough to reduce the company’s debt to equity ratio, which determines its ability to generate cash to meet its short and long term obligations. Net working capital ratios can be used to calculate the potential cost savings that could result from the establishment of a net working capital cycle.