09 Apr What is Net Operating Working Capital?
A company’s net operating working capital (NOWC) indicates its ability to pay off its operating liabilities with its operating assets. It is essentially a measure of a company’s liquidity.
What is net operating working capital?
It is absolutely essential for every company to manage its net working capital in an efficient manner. NOWC is defined as:
Cash + Accounts Receivable + Inventory + Accrued Expenses – Accounts Payable.
A company that has an adequate cash balance will find it easier to meet its financial commitments. Conversely, a business that is constantly bleeding cash will find it difficult to survive in the long run. Of course, it could replenish its cash levels from long-term sources, but at a certain point, investors and lenders would refuse to provide any additional funds.
When analyzing the NOWC of a company, it is important to remember two points:
- What are the components of the NOWC? If it comprises of large amounts of inventory that is not easy to liquidate, it may indicate an unhealthy position.
- Similarly, constantly increasing debtors may result in a larger NOWC. But if the firm is unable to recover its debts, it could face liquidity problems in the future.
Example of net operating working capital
The balance sheet of Carrow & Sons, a supplier of building materials, shows the following data:
Accounts Receivable: $120,000
Accrued Expenses: $7,000
Accounts Payable: $85,000
The NOWC of Carrow & Sons is:
$25,000 + $120,000 +$45,000 + $7,000 – $85,000 = $112,000
The NOWC is at a comfortable level of $112,000. Carrow & Sons can pay off its operational creditors from its operating current assets and still have a substantial sum left over. Of course, this assumes that the inventory can be sold at the stated value and that the debtors will pay off their dues to the company in full.
A company’s NOWC tells you how well it is managing its liquidity. But it is important to analyze how the NOWC has been changing over a period of time. It is also important to study each component of the NOWC and see if it is reflected at its correct value.