Running a business firm required an adequate cash flow. To maintain it working capital plays a vital role. When if it asked what is working capital, in simple terms it will be described as it is what drives your business’ supply chain and sustains day-to-day operations. It is a measure of your firm’s short-term liquidity and hence net working capital is described as the difference between your current assets and current liabilities. However, when it comes to determining financial health, it is important to do the calculation to understand if you have a positive or negative net working capital.
Read on to find out how you can do so
What is Net Working Capital and How to Calculate It Working capital is what drives your business’ supply chain and sustains day-to-day operations. It is a measure of your firm’s short-term liquidity and hence net working capital is described as the difference between your current assets and current liabilities. However, when it comes to determining financial health, it is important to do the calculation to understand if you have a positive or negative net working capital. Read on to find out how you can do so Understanding current assets and liabilities Current assets are those that you can convert into cash in less than a year such as cash, debtors, inventory, etc.
- Cash: It includes money in hand, in your business’ bank account, cheques, securities like bonds, petty cash, and forms of currency that can be quickly converted into cash.
- Accounts receivable: It’s the amount that is owed to your company by others. For example, if you have dispatched a batch of stationery products to a shopkeeper with a 30-day payment period, the payment due is part of your accounts receivable.
- Inventory: Refers to raw materials and finished goods that you have for sale. Similarly, current liabilities can be split up into accounts payable, short-term borrowings, and accrued liabilities.
- Accounts payable: This is the amount that your business owes to suppliers and vendors. For example, you may have received a consignment of wood from a supplier with a 30-day payment window. Since you owe this amount, it falls under accounts payable.
- Short-term borrowings: Refers to the debt accumulated by your business that is due in 1 year. An example of this is a short-term bank loan that you take to finance rental costs for your manufacturing unit.
- Accrued liabilities: Indicates the expenses that your business has incurred, but not yet paid. Examples are payroll taxes and contributions you may have to make towards EPF and gratuity, and interest on a loan that has not yet been billed.
Calculating your Firm’s Working Capital
Now that you know what makes up current assets and current liabilities, learn how to calculate your net working capital with this example.
Think of your business has cash in hand amounting to Rs.8 lakh, and machinery worth Rs.40 lakh. Also, owing to peer-to-peer lending, a company owes you Rs.7 lakh.
Current assets = cash + machinery + accounts receivable = Rs.8 lakh + Rs.40 lakh + Rs.7 lakh = Rs.55 lakh At the same time, think that you need to repay a loan of Rs.30 lakh and make payments to suppliers amounting to a total of Rs.16 lakh.
Current liabilities = short-term borrowings + accounts payable = Rs.30 lakh + Rs.16 lakh = Rs.46 lakh
So, net working capital = current assets – current liabilities = Rs.55 lakh – Rs.46 lakh = Rs.9 lakh
How positive and negative working capital impacts your business The working capital of your business is positive when your current assets exceed your current liabilities, and negative when the reverse is true. The latter indicates that your business may have a hard time operating smoothly and in the worst case, may even go bankrupt. A positive working capital, another side, indicates that your supply chain finance runs efficiently. This is why it’s important to monitor your working capital closely, so you can take remedial action if your levels are low and stop it from impacting your revenue.