Net Working Capital and Business Model

 

Written by:Sarah Sharkey

Net Working Capital (NWC) is a crucial concept in finance that measures a company's short-term financial health and its ability to pay its current liabilities. In simple terms, it refers to the difference between a company's current assets and its current liabilities. Essentially, NWC represents the amount of cash a company can use to fund its day-to-day operations. 

What’s Included In Net Working Capital?

Current assets are those that can be converted into cash within a year, while current liabilities are those that must be paid within a year.

To figure out how to find Net Working Capital, the following items, which are typically included, must be introduced:

• Cash and cash equivalents: These are the most liquid assets a company has and include cash in hand, bank deposits, and short-term investments.
• Accounts receivable: This is the money that a company is owed by its customers for goods or services provided on credit.
• Inventory: This is the raw materials, work in progress, and finished goods that a company has on hand and expects to sell within a year.
• Prepaid expenses: These are payments made in advance for goods or services that will be received in the future.
• Other current assets: This includes any other assets that a company expects to convert into cash within a year, such as short-term loans to employees or deposits held by suppliers.
• Accounts payable: This is the money that a company owes to its suppliers for goods or services purchased on credit.
• Accrued expenses: These are expenses that a company has incurred but has not yet paid, such as wages or taxes.
• Short-term debt: This is any debt that must be repaid within a year, such as bank loans or lines of credit.

What Is Net Working Capital Formula?

The net working capital formula is quite simple and can be expressed as follows:

Net Working Capital = Current Assets - Current Liabilities

In other words, subtracting the total value of a company's current liabilities from the total value of its current assets will give you its net working capital.

Current assets include cash and cash equivalents, accounts receivable, inventory, prepaid expenses, and other short-term assets.

Current liabilities include accounts payable, accrued expenses, short-term debt, and other short-term obligations that the company owes.

The resulting net working capital figure gives an idea of how much cash a company has available to fund its day-to-day operations and short-term obligations. A positive net working capital indicates that a company has enough cash on hand to cover its short-term obligations, while a negative net working capital indicates that a company may have difficulty meeting its short-term obligations.

Uses Of Net Working Capital

Net working capital is an important financial metric for businesses, as it reflects the amount of cash a company has available to fund its day-to-day operations and short-term obligations. The following are some of the uses of net working capital:

• Assessing a company's liquidity: Net working capital helps investors and creditors assess a company's liquidity and ability to meet its short-term obligations. A positive net working capital indicates that a company has enough cash on hand to cover its short-term obligations, while a negative net working capital indicates that a company may have difficulty meeting its short-term obligations.
• Identifying cash flow issues: If a company has a negative net working capital, it may indicate that the company has cash flow issues, which could lead to difficulties in paying its bills and meeting its short-term obligations.
• Evaluating a company's financial health: Net working capital is an important metric that investors and creditors use to evaluate a company's overall financial health. A company with a positive net working capital is generally considered financially healthy, while a negative net working capital can indicate potential financial distress.
• Managing inventory levels: Net working capital can be used to help manage inventory levels. A high level of inventory can tie up cash, while a low level of inventory can result in lost sales. By managing inventory levels, a company can optimize its net working capital and improve its overall financial performance.
• Financing business operations: Net working capital can be used to finance a company's day-to-day operations, such as paying bills, purchasing inventory, and meeting payroll obligations. By maintaining a positive net working capital, a company can ensure that it has enough cash on hand to meet its short-term obligations and keep the business running smoothly.

Why Is Net Working Capital Important?

Net working capital is an important financial metric for businesses because it reflects the amount of cash a company has available to fund its day-to-day operations and short-term obligations. 

The following are some of the reasons why net working capital is important:

• Indicates liquidity: Net working capital indicates a company's liquidity, or its ability to pay its short-term obligations. A positive net working capital means a company has more current assets than current liabilities, indicating that it can meet its short-term obligations without difficulty.
• Provides insight into financial health: Net working capital can provide insight into a company's overall financial health. A positive net working capital indicates that a company is financially healthy, while a negative net working capital can indicate potential financial distress.
• Helps with managing inventory: Net working capital can help businesses manage their inventory levels. A high level of inventory can tie up cash, while a low level of inventory can result in lost sales. By managing inventory levels, businesses can optimize their net working capital and improve their overall financial performance.
• Assists with cash flow management: Net working capital is an important metric for cash flow management. By monitoring their net working capital, businesses can ensure that they have enough cash on hand to meet their short-term obligations and keep their operations running smoothly.
• Used by lenders and investors: Lenders and investors often use net working capital to evaluate a company's financial health and its ability to meet its short-term obligations. A positive net working capital can be seen as a positive sign for investors and lenders, indicating that a company is financially stable and able to meet its obligations.

How Net Working Capital Is Calculated 

Net working capital is a useful metric for business owners. For this reason, it is imperative to understand how it works. Let’s explore how to calculate Net Working Capital:

Calculating Current Assets

Start by adding up all of the current assets of your business.

Assets to Include:

• Cash 
• Accounts Receivable
• Inventory

Net working capital measures the difference between and business's current assets and current liabilities..

Calculating Current Liabilities

Add up your current liabilities facing your business.

Liabilities to Include:

• Accounts Payable 
• Debt Payments
• Other Expenses on the Horizon

Subtract Current Liabilities From Current Assets

At this point, you can subtract your current liabilities from your current assets. The number represents the net working capital of your business.

Example Of Net Working Capital Calculation

• Current Assets: In total, the business has $150,000 in current assets.
• Current Liabilities: In total, the business has $100,000 in current liabilities.
• Working capital: With these numbers, the business would have $50,000 of net working capital.

How To Interpret Net Working Capital

Net working capital (NWC) is a financial metric that measures the difference between a company's current assets (such as cash, inventory, and accounts receivable) and its current liabilities (such as accounts payable and short-term debt).

While it is easy to understand how to calculate Net Working Capital, interpreting it involves analyzing the company's ability to meet its short-term financial obligations, manage its cash flow, and invest in growth opportunities.

A positive NWC indicates that a company has enough current assets to cover its current liabilities, which is generally seen as a positive sign. This indicates that the company has sufficient liquidity to cover its short-term financial obligations, such as paying suppliers, meeting payroll, and servicing short-term debt. A high positive NWC may also indicate that the company has room to invest in growth opportunities or pay dividends to shareholders.

Conversely, a negative NWC indicates that a company's current liabilities exceed its current assets. This may indicate that the company is facing financial difficulties and may struggle to meet its short-term financial obligations. 

However, a negative NWC may also be a sign of a company that is in a growth phase, investing heavily in its future growth, and thus temporarily consuming more cash than it generates.

In addition to analyzing the absolute value of NWC, it is also important to consider the change in Net Working Capital over time. A steady or increasing NWC may indicate a stable or growing business, while a declining NWC may indicate declining business performance or difficulty managing cash flow.

Problems With Net Working Capital

Here are some specific problems that may arise with NWC:

• Inadequate working capital: If a company's current assets are not sufficient to cover its current liabilities, it may struggle to pay its bills and meet its obligations. This can lead to cash flow problems and a decline in business operations.
• Poor management of inventory: A company that holds too much inventory can tie up cash that could be used for other purposes, while a company that holds too little inventory may not be able to meet customer demand. Both scenarios can lead to problems with NWC.
• Slow collections on accounts receivable: If a company is slow to collect payments from customers, it may struggle to pay its own bills and meet its obligations. This can lead to cash flow problems and a decline in business operations.
• Too much short-term debt: If a company has too much short-term debt, it may struggle to pay it back in a timely manner, leading to cash flow problems and potentially even bankruptcy.
• Inaccurate forecasting: If a company's forecasts of future cash flows are inaccurate, it may not be able to plan effectively for its short-term financial needs. This can lead to problems with NWC if the company finds itself short of cash to meet its obligations.

How To Improve Net Working Capital

Improving Net Working Capital (NWC) involves managing a company's current assets and liabilities in a way that maximizes cash flow and short-term financial stability. Here are some strategies that can help improve NWC:

• Increase sales revenue: Increasing sales revenue can provide a boost to current assets, which can improve NWC. This can be achieved by implementing effective marketing strategies, expanding product lines, and improving customer service.
• Improve inventory management: Effective inventory management can help optimize cash flow by ensuring that inventory levels are neither too high nor too low. This can be achieved by implementing inventory control systems, improving supply chain management, and forecasting demand accurately.
• Reduce accounts receivable collection time: Companies can improve NWC by collecting payments from customers more quickly. This can be achieved by improving billing procedures, offering incentives for early payment, and implementing collection procedures.
• Negotiate better payment terms: Negotiating longer payment terms with suppliers can help improve NWC by providing more time to pay bills. This can be achieved by improving vendor relationships, negotiating better pricing, and exploring alternative financing options.
• Reduce short-term debt: Companies can improve NWC by reducing their reliance on short-term debt. This can be achieved by implementing cost-cutting measures, exploring alternative financing options, and improving cash management practices.
• Improve cash management: Effective cash management practices, such as optimizing cash inflows and outflows, can help improve NWC. This can be achieved by implementing cash management systems, improving forecasting accuracy, and managing cash balances effectively.
• Regularly monitor NWC: Regularly monitoring NWC can help companies identify potential problems and take corrective action before they become serious. This can be achieved by using financial metrics to track NWC, conducting regular audits, and reviewing financial statements regularly.

Reporting Net Working Capital

To report NWC, a company typically prepares a balance sheet that includes current assets and current liabilities. The difference between current assets and current liabilities is the company's NWC. 

The balance sheet should clearly distinguish between current and noncurrent assets and liabilities, and provide a breakdown of the different components of NWC, such as inventory, accounts receivable, and accounts payable.

When reporting NWC, it is also important to provide context and explain any significant changes or trends over time. For example, if NWC has decreased, the company should explain why this has happened and what steps it is taking to address the issue.

NWC can also be analyzed in relation to other financial metrics, such as the company's cash conversion cycle, which measures the time it takes for a company to convert its investments in inventory and accounts receivable into cash. This can provide additional insights into a company's short-term liquidity and operational efficiency.

In summary, reporting NWC is an essential part of a company's financial reporting process, and should be presented clearly and with context to help stakeholders understand the company's financial health and short-term liquidity.

Net Working Capital Vs. Operating Cash Flow

Below is a table that compares net working capital and operating cash flow

Aspect	Net Working Capital	Operating Cash Flow
Definition	The difference between current assets and liabilities	The amount of cash generated or used by a business operations.
Time Period	Snapshot of a company's short-term liquidity	Measures cash flows over a period of time (usually a quarter or year)
Components	Current assets and current liabilities	Cash flows from operating activities
Purpose	Measures a company's ability to meet short-term obligations	Measures the amount of cash generated or used by core operations
Calculation	NWC = Current Assets - Current Liabilities	Operating Cash Flow = Net Income + Non-cash Expenses - Changes in Working Capital
Interpretation	Positive NWC is generally preferred, but varies by industry and company size	Positive OCF indicates that a company can generate enough cash to support its operations
Limitations	Does not take into account cash flows from operating activities	Does not account for capital expenditures or debt payments
Usefulness	Useful in determining a company's short-term liquidity	Useful in evaluating a company's ability to generate cash from its operations
Relationship	NWC can impact OCF, and vice versa	Positive NWC may indicate positive OCF, but they are not directly related
Industry	Examples Retail, manufacturing, and service industries	High-tech, research and development, and biotech industries

What Does A Positive And Negative Net Working Capital Mean?

Net Working Capital (NWC) is a measure of a company's short-term liquidity, which is its ability to meet short-term obligations. A positive NWC indicates that a company has sufficient current assets to cover its current liabilities, while a negative NWC indicates that a company may have difficulty meeting its short-term obligations.

Here are 7 bullet points explaining what a positive and negative NWC means:

• Positive NWC: A positive NWC indicates that a company has sufficient current assets to cover its current liabilities. This means that a company can meet its short-term obligations and is better equipped to handle unexpected expenses or changes in the business environment.
• Negative NWC: A negative NWC indicates that a company may have difficulty meeting its short-term obligations. This means that a company may struggle to pay its bills and may have to rely on external financing to stay afloat.
• Preferred NWC: While a positive NWC is generally preferred, the optimal amount of NWC varies by industry and company size. For example, a manufacturing company may require a higher level of NWC due to the need for inventory and raw materials, while a service-based company may require less NWC.
• Causes of Negative NWC: Negative NWC can be caused by a variety of factors, including poor inventory management, slow collections on accounts receivable, and too much short-term debt.
• Consequences of Negative NWC: Negative NWC can lead to cash flow problems, difficulties in paying bills and meeting obligations, and potentially even bankruptcy.
• Improving Negative NWC: To improve a negative NWC, companies can take steps such as improving inventory management, collecting payments from customers more quickly, and reducing short-term debt.
• Watch for Red Flags: Investors and analysts should pay close attention to NWC trends, as a declining or negative trend may indicate underlying problems in a company's operations or financial health.

A positive NWC indicates a company's short-term liquidity is healthy, while a negative NWC suggests that a company may have difficulty meeting its short-term obligations.

Final Word

In summary, Net Working Capital (NWC) is a measure of a company's short-term liquidity, which is its ability to meet short-term obligations. It is calculated by subtracting current liabilities from current assets. 

A positive NWC indicates that a company has sufficient current assets to cover its current liabilities, while a negative NWC indicates that a company may have difficulty meeting its short-term obligations.

Net Working Capital - a reflection of the design and execution of a business model

An organization can improve its financial performance without increasing revenues or lowering costs. With two organizations generating the same revenues and costs, the one that needs the least financial investments will generate the highest return on investments, and have the highest freedom of action. Many interesting and innovative business models implemented by companies such as Dell, Southwest Airlines, Toyota and Zara, have at its core an effective Net Working Capital model. This post is an introductory to the concept and will be followed by a post exploring it further, with examples from different industries.

What is Net Working Capital?

Net Working Capital (NWC) is defined as current assets minus current liabilities and is a financial metric which represents operating liquidity available to a business. It indicates the firm's ability to convert its resources into cash and by quickly turning resources into cash, have the ability to put the cash to use again, ideally to reinvest and make more sales.

Current Assets comprises of cash and cash equivalents, inventory, and accounts receivable. To take a manufacturing company as an example: it needs cash to buy raw material or components (inventory), use the material in production (work-in-process inventory) to produce finished-goods (finished-goods inventory), to sell to customers who might get some days to pay (creating accounts receivables).

Current Liabilities includes accounts payable for goods, services or supplies that were purchased for use in the operation of the business. In the case with the manufacturing company above perhaps it didn't have to pay cash for the raw material or components, but had some creditor days (creating accounts payable).

Net Working Capital can thus be positive or negative depending on when raw material is paid to suppliers, how long the goods are in inventory and when goods are paid by customers.

Positive NWC:

Negative NWC:

Let's assume that the manufacturing company buys raw material and convert it to products which it sells on average after a total of 20 days in inventory, plus providing customers with 20 days to pay, creating total current assets (other than cash) of 40 days.

Scenario 1 - Positive NWC: The manufacturing company needs to pay its suppliers in an average of 30 days. The cash it takes to finance the business is 10 days multiplied by average sales per day.

Scenario 2: Negative NWC: The manufacturing company needs to pay its suppliers in an average of 60 days. The company has 20 days multiplied with the average sales per day in cash surplus, cash that can be used for other things.

Funding growth

If the company in Scenario 1 is growing rapidly, increasing amounts of cash will be needed to pay its suppliers and eventually to hire more people, and the cash from sales will never be able to catch up thus other sources of cash is needed. Failing to find additional sources of cash, profitable companies sometimes go bankrupt. If the company in Scenario 2 is growing rapidly, increasing amounts of cash will be available to fund the growth and other initiatives.

Capital always comes at a price

Different business models require different amounts of working capital depending on things such as the need for different inventory, when customers pay and when suppliers are being paid. Companies with business models that can use cash from customers require less investment and can thus generate higher return on those investments. Companies with business models that need lots of working capital will have to raise it from somewhere and capital always comes at a price.

How much NWC is needed?

All components of a business model have an effect on NWC and every organization needs enough cash and inventory to do its job. Reducing inventory too much and the production might be interrupted, push the suppliers too hard and they might run out of cash and perhaps go bankrupt, push the customers too much and they will go to someone else, too much leverage using other organization's assets and you might lose control. Finding the right balance is a challenge and using the business model concept to identify tied up cash can be a very useful exercise.

Using the business model concept

In the next post I will exemplify how the business model concept and business model innovation can have a huge direct effect on Net Working Capital but also have indirect effects such as improved efficiency, quality or customer satisfaction. It will be a "How to" post with questions to ask to find where money is tied up, and money tied up in working capital is money not available to grow the company.

Net Working Capital - Inventory & business models

In the previous chapter, introducing Net Working Capital (NWC), some of the conclusion were that money tied up in working capital is money not available to grow the company, that different business models need different amounts of working capital, that organizations that need lots of working capital will have to raise it from somewhere and that capital always comes at a price.

Also, we saw that NWC can be measured in days, in what is called the Cash Conversion Cycle (CCC) and that the noncash portion of NWC can be both positive and negative:

Positive NWC:

Negative NWC:

In this post I will focus on inventory and the role it has in different business models, and how different organizations have reduced their working capital by reducing DII, days in inventory.

Keeping an inventory

Businesses with value propositions that directly or indirectly involve physical products generally need to have some form of inventory. This can be divided into raw materials, work-in-process, finished goods, goods for resale and spare parts. Determining the optimal level of inventory requires that the benefits and costs are measured and compared.

DII - Days in inventory

Days in inventory measures the number of days inventory stays in the system. The lower the inventory days, as long as there is enough inventory on hand to meet customer demands, the better. In some businesses such as wholesaling and retailing inventory constitutes a very large percentage of total assets, and a difference in DII can spell the difference between success and failure.

Benefits of holding inventory

The reasons for keeping an inventory of raw materials and components are to meet uncertainties in demand, supply, production, and movements of goods, to get quantity discounts, to give the organization flexibility with the respect to timing the purchase of raw materials, scheduling production facilities and employees. If rising prices, shortages of specific items, or both are forecasted for the future, maintaining a large inventory ensures that the company will have adequate supplies at reasonable costs. Work-in-process inventory give each operation in the production cycle a certain degree of independence and minimize costly delays and idle time. The benefits of having finished goods inventory are to be able to fill orders promptly, minimize lost sales, and avoid shipment delays and damaged reputation due to stock-outs. Spare parts are kept to minimize costly delays and idle time.

Costs of holding inventory

There are a number of inventory-related costs, including ordering costs, carrying costs and stock-out costs.

Ordering costs are all the costs of placing and receiving an order from an external or internal source. When ordering from an external source there are costs such as preparing purchase requisitions, expediting the order, receiving and inspecting the shipment, and handling payment. Costs within a company can be production setup costs such as expenses incurred in getting the plant and equipment ready for a production run.

Carrying costs represent all the costs of holding items in inventory and include storage and handling costs, obsolescence and deterioration costs, insurance costs, taxes, and the cost of the funds invested in inventories. The later in the production process, the more funds have been invested in the inventory and the more working capital is tied up:

Stock-out costs are incurred whenever a business is unable to fill orders because the demand for an item is greater than the amount currently available in inventory. A stock-out in raw materials generates expenses in placing special orders and expediting incoming orders, in addition to the costs or any production delays. When a stock-out in work-in-process occurs, stock-out costs include the costs of rescheduling and speeding production, and may also result in lost production costs if work stoppages occur. A stock-out in finished goods inventory may result in customers deciding to purchase the product from a competitor and in potential long-term losses if customers decide to order from other companies in the future.

Business models using Just-in-Time inventory

With just-in-time inventory management, required inventories are supplied to the manufacturing process at precisely the right time. This reduces the need for inventory, making the production more agile and able to adapt to changing customer needs. The concept, also known as lean manufacturing, was developed Toyota Motor Corporation in the 1950's, and often requires that the supplies are standardized, that the suppliers are highly trustable and close to the manufacturing plant. As there is very little buffer inventory between work stations, the quality and timing must be precise to prevent stock-outs.

Business models reducing product uncertainty

In most business models future sales is uncertain resulting in high inventory of some items and stock-out in other items. To take the apparel industry as an example it is difficult to create hit products on a continuous basis, and predict the demand down to the style, color and size, resulting in inventory of unwanted clothes. Threadless' business model uses an online community to contribute and vote for t-shirt designs, and only produce the ones that becomes highly popular. Threadless t-shirts are run in limited batches with 9 new designs a week, and when sold out reprinting only occurs when there is enough demand for a new batch.

Zara, on the other hand, is a vertically integrated retailer with that can go from design to finished goods in stores in as short as two weeks. Shop managers report back every day to designers on what has and has not sold, information that is used to decide which product lines and colors to keep or alter, and whether new lines should be created. Reducing the time to get the clothes into the shelves and the batches of clothing in small quantities also keeps the costs down by keeping stocks low, and if a design doesn't sell well within a week, it is withdrawn from shops, and further orders are canceled.

Business models where customers pay in advance

Getting paid before producing anything is the main ingredient in the recipe for Negative Net Working Capital, but also for limiting the need for inventory. Dell revolutionized the computer industry when it in the 1980s pioneered the configure-to-order approach, delivering individual PCs configured to customer specifications. It could thus keep a minimal inventory in an industry where components depreciate very rapidly.

The subscription revenue model is another way of getting paid in advance and to get information about the quantity to produce. The subscription-based periodical publishing industry has for a long time been able to have Negative Net Working Capital, keeping inventory to a bare minimum and with large current liabilities for all issues due for the rest of the subscription period.

Business models reducing the need for spare parts

Some business models require an inventory of spare parts to assure customer satisfaction and minimize costs and delays if something needs replacement. Maintaining inventory of spare parts has associated costs. The decision what to keep "just in case" is thus a compromise between inventory cost and the probability and cost of failure. One way to reduce inventory of spare parts is to reduce the number of different types of equipment for which spare parts is needed. To keep its operating model lean Ryanair only fly one model of airplane, a stripped-down Boeing 737, reducing its inventory of spare parts and reducing the need to train its maintenance staff.

Analyzing the need for inventory

So what is it in your business model that requires inventory? What is the reason for having it? What would you need to do to lower or reduce it? What would happen if you reduced it too much and could there be other ways to compensate for stock-out that is more cost effective?

Analyzing the customer

Do some existing customers or market segments result in higher needs for expensive inventory? Do customers appreciate all versions of the products and services or can it be reduced? Do customers realize (and perhaps pay for) the service of getting extra orders or spare parts in short time? Would some customers even be willing to pay more if you held the right inventory? What creates value for them?

Analyzing the value proposition

Would it be possible to configure value propositions to reduce the need for inventory? Would it be possible to create value propositions due to the fact that you keep inventory? What are the level of service commitments you make to your partners and customers? Is it possible to modularize components and products and perform final assembly later in the process? Is it possible to deliver in any other way reducing the days in inventory? Can someone else, such as suppliers, partners or customers keep your inventory? Could you reduce someone else’s costs by holding their inventory and charge for it?

Analyzing resources and activities

What are the activities that need expensive inventory? Can the activities be made more lean without disrupting operations? Can better information on how much will be needed control production? Is there an inventory policy on what products or components to keep in inventory? Can it be bought instead of manufactured?

Analyzing suppliers and partners

Can suppliers and partners be the ones that keeps inventory? Would other suppliers or partners be willing to do it? What if we change specifications? What if we change batch sizes from supplier or internal processes? Do we keep inventory due to uncertain delivery from suppliers? Could this be changed? What if we configure the value network in a different way? Could we get quantity rebates? Are we being fooled by quantity rebates? Could we negotiate lower minimal order sizes?

Every dollar freed from inventories contributes to the cash flow of the company. But the reduction of Net Working Capital not only generates cash, it also forces companies to produce and deliver faster and run their businesses more efficiently.

https://tinyurl.com/e9u65tdv