Explains what is working capital, what assets are included in it, and how to calculate working capital, plus how to calculate net working capital.
What is working capital: definition
Working capital – or capital required for operations – referred to the current assets of the company which is needed to control the operation to maintain. The capital required for operation comes from cost and performance accounting.
What is included?
You should include current assets, all assets of a company designated to be implemented, ie their inventory changes frequently through purchases and sales. Working capital is often financed with short-term debt and supplier credits and therefore does not have to be fully covered by long-term loans. Nevertheless, when applying for outside capital, the working capital should be explained in the financial section of the business plan.
The assets that are included are only in the company for a short time, but in addition to the fixed assets, they are used permanently for business operations. When establishing a business, it is therefore necessary to, determine how much working capital has to be used and what type of financing should be used for it.
Objects that are intended for the operational processes of production and sales are usually also counted as working capital.
Working capital must be shown on the balance sheet on the assets side. It is composed of the inventories, such as raw and operating materials, finished products and goods; from accounts receivable such as accounts receivable from deliveries and services and from liquid funds such as checks, cash in hand and credit balances with banks. How you manage that capital can be critical.
How to calculate working capital
Working capital is calculated by adding together Non-depreciable fixed assets (plus) depreciable fixed assets (plus) non-balanced, operationally necessary fixed assets, then substracting balanced, non-operationally necessary assets. In simple terms, the formula is:
Non-depreciable fixed assets
+ depreciable fixed assets
+ non-balanced, operationally necessary fixed assets
— balanced, non-operationally necessary assets
How to calculate net working capital (NWC)
Often abbreviated as NWC, this is a measure used to monitor changes in liquidity. This is understood to mean the current assets of a company, from which are subtracted the short-term liabilities.
The current assets are required to process the company’s operational activities. These current assets are financed with short-term borrowed capital. Thus, the NWC is the capital that the company has to finance over the long term for its operational activities. If working capital increases in new projects, the increase in working capital must also be financed.
In short, NWC is calculated by subtracting current assets from current liabilities. Current assets include inventories, other assets, receivables , securities and liquid funds. In other words, current assets include all values that are not fixed assets, i.e. are not invested in the company for the long term.
Debt capital that has a maximum term of one year is counted as short-term liabilities. Some only deduct non-interest-bearing liabilities from current assets when calculating net working capital. However, according to the current definition, this is not the correct method.
This calculation of NWC (also known as net current assets) indicates the percentage (ratio) to which the short-term borrowed capital is covered by the current assets. The ratio is also known as the liquidity coefficient.
Short-term borrowed capital is made up of short-term liabilities with a term of up to one year, tax provisions, other provisions and deferred income. Liquid funds consist of cash in hand, checks and bank balances.
NWC on the balance sheet
The negative NWC indicates that suppliers pre-finance the sales, so to speak. If there are doubts about the company’s liquidity, the NWC is determined. Opportunities for improvement can be used in various areas. Receivables management must become more active and deal with the customers’ payment terms. The NWC consists of the following areas:
- Liquid funds, namely receivables,
- Supplier liabilities.
If the NWC is negative, the accounts receivable and inventory should be reduced. The following signs must be observed: Is the NWC increasing? Is the difference between receivables for short-term liabilities versus sales disproportionately high? Are there specific liquidity bottlenecks? The NWC is decisive for the calculation of sales. The negative NWC indicates that the suppliers, so to speak, pre-finance the sales. This is to be understood in such a way that the entrepreneur pays the suppliers as late as possible.
Why is it important?
NWC enables the company to determine its net financial needs that it needs for short-term assets. It is also said that it denotes that part of the assets that is available in the short term to generate sales and is not financed by borrowed funds. The main difference to working capital in this calculation is the correction of the current assets by the liquid funds.
The rule of thumb for NWC is that the ratio of current assets and short-term borrowed capital should be at least 100%. In this case, the NWC is balanced and amounts to zero. From the banks’ point of view, the net working capital ratio should be at least 120-130%.
Working capital should always be positive. A negative working capital indicates failure to comply with the golden rule of balances: Lack of coverage of fixed and long-term current assets by equity and long-term debt) However, negative working capital can also mean that suppliers pre-finance sales.
NWC and the logistics chain
Logistics affects NWC. This includes the procurement of raw materials through to production and goods issue to the end customer. Several companies are involved in these workflows. Criteria to be considered:
- Material flow,
- Flow of information,
- What are the contractual rights of the corresponding contracts between customers and suppliers,
- Cash flow.
Logistic solutions can only be realized with the help of adequate financial resources. The NWC consists of receivables and inventories; supplier liabilities are reduced. Opportunities for optimization must be found in terms of quality, time and money.
When selling a business
In contracts drawn up to buy a company, NWC is of great importance. In the case of companies that are seasonally dependent and with sharply fluctuating net working capital, the risks cannot be precisely defined. The company’s history is also of great importance. Inventories and supplier liabilities are to be taken into account in these transactions; the determination of NWC is not the only decisive factor in being able to objectively evaluate the company.