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The basics of net working capital formula

Net working capital refers to the calculation of liquidity that shows the ability of a company to pay off its liabilities with the aid of current assets. This is crucial for the vendors, general creditors and management as it shows that the company has short term liquidity.

The net working capital formula which is much like working capital ratio lays emphasis on liabilities which include accounts payable, vendor notes and trade debts that have to be paid off in the current year. It does make sense that the creditors and vendors would be interested in the current assets to be translated into cash during the current year and that can be utilized for clearing the liabilities. If a company cannot meet the obligations associated with the current assets, then it is forced to make use of the long term assets in order to pay off the current obligations. This may result in decreased sales and operations.

The net working capital formula can be calculated by deducting the current liabilities from the current assets. The current assets which are made use of in this calculation include accounts, cash, short term investments and inventory. The current liabilities include accrued expenses, customer deposits, trade debt and accounts payable. Few people include a portion of the long term debt in the liabilities as well while using the working capital formula. While calculating net working capital formula, the current portion of the long term debt is taken into consideration. This truly makes sense as it branches from an obligation that is of long term. One needs to repay the current debt portion during the current year.

A positive result obtained from the net working capital formula always hints a positive outcome. Having a positive value shows the investors and the creditors that the company is capable of generating from its operations to with the current assets the current obligations. A large positive value would hint that the business has sufficient capital to rapidly expand its activities and to take up additional debt from the investors. It would hint that the company is capable of finding its expansion activities with the aid of its current operations.

A negative result obtained from the net working capital formula hints the investors and creditors that the company is not able to produce enough capital to clear its current debts. If this value grows over time, the company will have to sell its long term assets for the payroll and other current obligations. The company would be declared bankrupt if this value keeps on growing and no action is being taken to done anything.

It is vital to remember that a negative value of the working capital can prove out to be worse but it doesn’t really imply that the company would shut down soon. It is just a sign that the company’s short term liquidity is not good. This factor helps in having a sustainable and a healthy business. A positive value doesn’t imply that the company cannot convert its receivables or inventory to cash. It just implies that they have more current assets than the liabilities currently. However, it can’t pay the creditors in the inventory. This doesn’t really matter. A negative working capital doesn’t really imply that the company is performing really poor.

The value and the sign of working capital hint whether a company’s short term liquidity is decreasing or increasing. A company although having a negative working capital can improve continually over time and can be viewed to be stable than a business with a positive working capital.