What is Net Working Capital Ratio?
Net Working Capital Ratio is a ratio analysis tool to measure the liquidity position of a company. This ratio shows the firm’s ability to pay off its current liabilities with current assets.
This measurement is very important to the administration, vendors, and general creditors and even investors because it shows the company’s short-term liquidity.
It shows risk apatite as well as the ability of management to use its assets efficiently.
It only is sensible the vendors and creditors would really like to visualize what quantity current assets, assets that are expected to be converted into taking advantage the present year, are available to pay money for the liabilities which will become due within the coming 12 months.
Net Working capital (NWC) is the difference between a company’s current assets and current liabilities. A positive net working capital indicates an organization has sufficient funds to fulfill its current financial obligations and invest in other activities.
That’s why Net Working Capital Ratio is an important indicator of your business’s financial health—for yourself and for lenders, investors, and other third parties, too.
As the much more working capital company has as much more readily available liquid cash for the company is in the short-term. You can pay off your business’s debts and obligations, plus have money left over to fuel growth and cover emergencies.
On the other hand, a business that’s struggling to cover expenses might not be able to survive much longer.
Advantage of Net Working Capital Ratio:
- A positive sign in net working capital tells a company can meet its present financial obligations.
- A company can invest in order to its operational needs if more than 1net working capital.
- This ratio also provides a cushion for the company when the company needs some extra more cash.
- It helps in maintaining the goodwill of the firm.
- It helps in maintaining the solvency of the firm.
- It helps the firm in getting a regular supply of raw material.
- It helps the firm in getting a regular return on investment.
- It helps the firm in getting payment.
- NWC helps a company to surpass the emergency.
- This ratio assists the firm in getting any loan easily by approaching the banks.
- It helps the firm in getting a cash discount.
Disadvantage Net Working Capital:
- When a company has high current NWC means the company’s business isn’t using its current assets for business operation efficiently.
- Net working capital (NWC) does not always give an accurate liquidity position because some current assets can’t be easily converted to ready cash.
- It leads to excessive debtors.
- It spares funds are of no use and earn no profit.
- Sometimes fails to maintain the relationship with the banks due to no requirement of funds.
- Sometimes leads to unnecessary purchasing
Formula of Net Working Capital Ratio
There are different ways to calculate net working capital, depending upon what an analyst wants to include or exclude from the value.
Analysis and Interpretation of Net Working Capital
Working capital Ratio expressed to the decisions pertaining to working capital and short-term financing for the company.
The objective of the working capital ratio is to ensure that the company is capable to continue its operations. It has sufficient cash inflow to satisfy the short-term present debt and operating expenses of the company.
These involve overseeing the current assets and the current liabilities of the firm.
Most common policies and techniques for the management of working capital are:
- Cash management: identify the optimal balance. This provides a business to convene day to day expenses and payments but reduces cash holding costs.
- Inventory management: identify the optimal level of inventory. This provides a business continuation without uninterrupted production. It reduces the investment in raw materials, minimizes reallocation cost, and hence amplifies cash flow.
- Debtors’ management: identify the appropriate credit policy. This provides a business to use credit stipulations which will attract more customers. It extracts more impact on cash flow will be compensated by increased revenues of a company.
- Short term financing: identify the appropriate source of financing, by choosing between supplier credit (ideal for inventory financing), bank loan or factoring (accounts receivable financing), or create a mix of financing.
Net Working Capital Formula Example
Let’s an example of how to calculate net working capital, using a sample business called XYZ Corp. We begin with the company’s assets and liabilities for the coming year:
XYZ Corp Current Assets:
- Cash in the bank: $100,000
- Outstanding accounts receivables: $400,000
- Inventory: $500,000
Total current assets = $100000 + $400000 + $500000 = 10.00 Lakh i.e. $1 million
XYZ Corp Current Liabilities:
- Outstanding accounts payable: $300,000
- Short-term debt payments due this year: $30,000
- A portion of long-term debt due this year: $25,000
- Other accrued expenses for this year (e.g. rent, payroll, etc.): $400,000
Total current liabilities = $300000 + $30000 + $25000 + $400000 = $755,000
XYZ Corp’s Net Working Capital = Current Assets – Current Liabilities
$1000000 – $755,000 = $245,000
XYZ Corp has $245,000 of working capital. The company will have an estimated $245,000 leftover at year’s end after paying all of its expenses and obligations. That means XYZ is in a strong financial position for the coming year.