What it means:

Net Working Capital (NWC) is a measure of a company's liquidity and operational efficiency, calculated by subtracting current liabilities from current assets. It represents the amount of capital available for day-to-day operations after covering short-term obligations. Typically, budgeting and planning focuses on the change in NWC.

Generally, a positive NWC amount means that you are holding significant assets that are not cash but can convert to cash quickly such as Accounts Receivables, Inventory, Unbilled Revenue. On the flip side, a negative NWC amounts means that you are holding more liabilities than assets, typically if you have unpaid invoices, allocations for bonuses that haven’t been paid yet, or collected cash for undelivered services.

Why it matters:

NWC is crucial because it indicates a company's ability to meet its short-term financial obligations and fund its ongoing operations. Here's why it's important:

1. Liquidity Management: NWC helps in managing liquidity effectively by ensuring that the company has enough resources to cover its short-term debts without disrupting its operations.

2. Operational Efficiency: A positive NWC indicates that the company has sufficient current assets to cover its short-term liabilities, reflecting efficient management of working capital.

3. Financial Health: Monitoring NWC over time provides insights into the financial health of the company. A declining NWC may signal potential liquidity issues or inefficiencies in managing working capital.

Places it is used:

NWC analysis is utilized across various industries and is especially important in sectors with high working capital requirements, such as manufacturing, retail, and distribution. It is a fundamental metric for assessing financial health and operational efficiency.

For example, retail companies often monitor NWC closely to ensure they have enough inventory to meet customer demand while managing accounts payable effectively.

Generally, when looking to the future, it is important to see if your NWC is going up or down. Often, companies quickly find themselves cash strapped when they are generating revenues but not collecting cash. This leads to a high NWC due to large volumes of accounts receivable.

Where it gets tricky:

Interpreting NWC requires context and understanding of industry dynamics and business cycles. While a positive NWC generally indicates healthy liquidity, excessively high NWC may suggest inefficient use of resources, such as excessive inventory or accounts receivable.

Additionally, different industries may have different benchmarks for NWC, making comparisons challenging. It's essential to consider industry norms and company-specific factors when analyzing NWC.

An example:

In the below situation, I’ve crafted up a particularly extreme example of the different outcomes we can see. In one scenario we are generating revenue and customers are paying immediately. In the other, they are taking 3 months to pay. Let’s see how this impacts our cash balance.