Net working capital is a measure of company liquidity and its is calculated as the difference between company current assets and current liabilities. Curren assets are all the assets that are available to the company in the next 12 months like for example cash, account receivable (unpaid bill by the company customers) , inventories of raw materials and finished good. The current liabilities, in the same way, are the short-term financial obligations that the company needs to pay in the next 12 months like account payables, short term debt, dividends, income taxes owned etc.
Since the net working capital is the difference between a company’s current assets and current liabilities, the formula for calculating net working capital is:
Net Working Capital = Current asserts - Current liabilities
A more granular formula for calculating net working capital will be:
Net Working Capital = (Cash and Cash Equivalents) + (Marketable Investments) + (Trade Accounts Receivable) + (Inventory) – (Trade Accounts Payable)
The networking capital is important because it is a measurement of the ability of the company to cover its short term liabilities by using the short term assets. It is a good indicator of a business efficiency and business solvency. Negative net working capital means that a company will typically need to borrow or raise money to remain solvent.
The elements of net working capital formula are the same as current ratio calculation. The current ratio divides the current assets by current liabilities and gets a number larger than 1 if the company has positive net working capital. So in a sense Net working capital is a liquidity measurement in the same way as current ratio.
Net working capital can also be used to estimate the ability of a company to grow quickly. If a company has substantial reserves of cash it can use that cash to quickly grow the business. Conversely, if the business does not have a good working capital buffer it has a limited potential to reinvest its assets quickly to stimulate growth.