What is Net Working Capital? Definition, Formula, Importance, and How to Calculate It

Net working capital includes short-term assets and liabilities. A positive net working capital indicates the good financial health of a company, and thus, lenders feel more confident in those businesses' growth potential. In this blog, you will learn about the net working capital definition and its importance while acquiring a Business Loan. Read on!

What is Net Working Capital?

The net working capital is a crucial factor while analysing a business. It reflects how smooth the company's cash flow can be in the upcoming years. Most commonly, the net working capital is computed by subtracting the non-debt current liabilities from non-cash current assets. The ideal reputation would be to hold a position where your venture boasts more assets compared to debts and liabilities.

Working Capital Explained

On accessing the balance sheet, any lender can find a completely sorted list of assets and liabilities. These are arranged in order of liquidity (i.e., current vs long-term), thus making it easy to evaluate the working capital. All you will have to do is subtract the current liabilities from the cumulative current asset value.

It is meaningful to first thoroughly scrutinise the 'operating activities' as most current assets and liabilities are listed there. However, you must remember that all current liabilities and assets are not tied to operations.

Therefore, it is  also mandatory to consider the investing and financing aspects, as those areas involve short-term debts and marketable securities. Getting all the components is crucial, as misinterpretations will directly impact an organisation's short-term financial obligations.

Why is Working Capital Important?

Working capital goes towards funding day-to-day operations and meeting short-term objectives. When a company has sufficient working capital it can comfortably pay off all its overhead expenses. This includes salaries of employees, bills due to various suppliers, and even tax and interest payments which are unavoidable.

Thus, a positive working capital exhibits a company's independence relative to Business Loan plans. For such ventures, lenders are more likely to disburse the requisite loan amount without imposing stringent conditions.

Also, by studying the working capital status, lenders can assume possible contingencies and future growth opportunities. Thus, having a clear view, they may be willing to enter into a mutually profitable long-term business relationship.

Advantages of Working Capital

These are the three major advantages of having adequate working capital:

1. Better Liquidity Management

Sufficient cash flow ensures that all daily operations are running smoothly. This impacts a business's overall performance and reflects its positive brand image.

2. Higher chances of earning short-term profits

The surplus working capital of a business often gets shifted towards additional investments. This can bring in short-term profits if the asset management is done systematically.

3. Aids in Decision Making

The stakeholders and top-level managers can arrive at vital conclusions more confidently after having a clear idea of daily fund requirements. It also helps them to switch the source of funds to maintain the sufficiency of working capital if needed.

Also Read:  9 Key Factors Affecting Your Working Capital

How to Calculate Net Working Capital?   

As the name suggests, the net working capital formula is used to calculate net working capital.

Your net working capital is your current assets minus your current liabilities. Hence, from the above example, your net working capital would be as per the net working capital formula:

Rs. 84 Lakh (current assets) – Rs. 45 Lakh (current liabilities) = Rs. 39 Lakh (net working capital)

So, net working capital is equal to:

Net Working Capital Formula = Current Assets – Current Liabilities

Positive vs. Negative Working Capital

Positive working capital simply infers that a business possesses sufficient liquidity of funds to clear off immediate liabilities. On the other hand, negative working capital is a cause of concern as the business may not be able to meet all of its immediate dues if only it depends on the current assets. Such a crisis can emerge from a temporary loss of liquidity, usually generated by huge cash liabilities or credit extensions.

What are Current Assets? 

Items on your balance sheet that can be converted into cash within a year are known as current assets.

Essentially, current assets can be used to pay for your business's operating expenditures.

Here are some examples:

1. Cash and Cash Equivalent

This includes any liquefiable investments of the business. For example, if a business has invested in stocks of a publicly traded company, then it counts as a cash equivalent. 

2. Inventory

This includes all the goods a business owns that have not been sold yet. It also includes any raw materials and partially assembled goods.

3. Accounts Receivable

This entails all the money that is due to come into the business. Suppose your business has cash worth Rs.24 Lakh and inventory worth Rs.60 Lakh. This means that you have current assets worth Rs.84 Lakh (Rs. 24 Lakh + Rs.60 Lakh).

Also Read:  Working Capital Cycle: Definition & Complete Overview

What are Current Liabilities? 

Current liabilities are those items on your balance sheet that need to be paid for within one year. Some examples of current liabilities include debt payable, payable accounts, employee salaries, and so on. 

Essentially, current liabilities are your short-term financial obligations. 

1. Payable Salaries

Usually, this is the biggest current liability of a small to medium-sized business. The wages that need to be paid to employees within one year are included as current liabilities.

2. Accounts Payable

This refers to any money that needs to be paid to vendors, utility services, rent, taxes, etc. .

3. Debts Payable

This includes any debt repayment that needs to be made within the space of one year. If you have long-term debt but some instalments must be repaid within the year, that counts as a current liability. 

If you need to pay Rs.30 Lakhs every year to your employees and you have an annual debt of Rs.15 Lakh, then your current liability is Rs.45 Lakh (Rs.30 Lakh + Rs.15 Lakh). 

How to Increase Net Working Capital?

If you're looking to increase your net working capital, you can follow the below-mentioned tips:

1. Unload Long-Term Assets for Cash 

Long-term assets do not count as current assets. This is because the value of these assets is spread out over a period of more than one year.

2. Refinance Your Debt 

Debt can account for a large portion of your current liabilities. A business may have lots of short-term debt, such as credit card payments and lines of credit. It is possible to refinance such debt and turn them into longer-term debt. For example, you can get a Business Loan to repay your short-term debt.  

3. Sell Excess Inventory 

A business may find itself in a position where it has a lot of excess inventory. You can review your inventory to find items that can be sold in the short term. Even though inventory counts as a current asset, it is still not as liquid as cash. This is because selling inventory can be more difficult than spending cash. 

How to Apply for a Business Loan Online?

To apply for a Business Loan, consider visiting the official website of Poonawalla Fincorp. To successfully apply, follow these steps:

• Step 1: Click on the 'Apply Now' and move to the application form.
• Step 2: Fill out the necessary details and submit the documents needed.
• Step 3: Finally, hit the 'Submit' button.

An executive will contact you for further discussion within a few working days.

To Conclude

In conclusion, you can apply for a Business Loan if you fall short of working capital. Lenders like Poonawalla Fincorp help you obtain a Business Loan at an attractive interest rate. Thus, check the eligibility criteria and apply, if needed to clear off your short-term debts. Also, as discussed above, other ways exist to increase a business's net working capital. Proper coordination would be needed amongst the top operative and managerial positions to put them into place.

Frequently Asked Questions

• What does net working capital mean?

Net working capital is the amount you have calculated as the difference between the current assets and current liabilities of a business.

• How do you calculate the net working capital ratio?

Net working capital ratio is calculated as per the following formula:

Net Working Capital Ratio = (Current assets - Current liabilities) ÷ Total Assets

• Why is calculating net working capital important?

Calculating net working capital is important to ensure that your business always has adequate capital to run smoothly.