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Net Working Capital Ratio

Overview Of Net Working Capital Ratio

Working capital refers to the money required to run the day to day operations of a business. It encompasses short term assets as well as liabilities. Short term refers to a one year time frame when it comes to understanding the working capital cycle. Net working capital would include reducing the current liabilities from current assets.

Current Assets for a business typically include: debtors, bills receivables, short term investments, cash and cash equivalents, prepaid expenses, inventories etc. Inventory comprises finished goods, work in progress items as well as raw material.

Current Liabilities comprise accounts payable, short-term debt obligations, interest payment due within the year under consideration including those on long term debt, salaries and taxes. The interest payable in the near term is included in this case as it will have to be paid within a year and there will be a cash outflow for the company for the same.

Net Working Capital = Current Assets - Current Liabilities

Let us take a numerical example. Assume the following are the number for XYZ Company:

Cash:

USD12,000

Bills Receivable:

USD4,000

Inventory:

USD14,000

Bills Payable:

USD8,500

Accrued Expenses:

USD1,500

Creditors:

USD4,500

Current Assets = Cash = Bills Receivable + Inventory + Other Debtors = 30,000

Current Liabilities = Bills Payable + Accrued Expenses + Creditors = 14,500

Therefore Net Working Capital = 30,000 - 14,500 = 15,500

If this number is positive it means that the company has sufficient funds to pay for liabilities arising in near term. In other words a company is well covered to meet it's near term obligations. A higher difference could also indicate that the company maybe in a good position to take on additional work or orders without having to raise external funds.

However it is important to note that the net working capital figure alone cannot be taken on face value. It has to be compared with liquidity ratios to understand the true positioning of the company with respect to its debt servicing capabilities in the near term. To illustrate further, the net working capital of a company maybe the same however one may have a current ratio of 1 and the other may have a current ratio of less than 1. It would mean that the first company is places a lot better in terms of meeting it's near term financial obligations than the second company.

Notably if the inventory within the current asset component is high, it would result in a higher net working capital but the company maybe finding it difficult to sell its goods and services as indicated by the inventory pile up. It would be important for the company to convert this into cash. If this continues for a long time, the company might not be able to service its short term debt and may have to utilise some of its longer term assets to meet its shorter term liabilities resulting in an asset liability mis-match.

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