It was earlier stated that there are two concepts of working capital. In a previous article, one of the types has been discussed. In this article, the focus is on networking capital.
Definition of Net Working capital
Net working capital is the difference between current assets and current Liabilities.
It is calculated by comparing current assets and current liabilities.
Current assets are assets which cash flow is within a year. And current liabilities are obligations of which repayments will occur within a year.
An important aspect of current assets is cash. It is cash that will be used to meet the entity’s current obligations.
If the current assets are higher than the current liabilities it is referred to as positive working capital (or net current assets).
If the value of the current assets is less than the current liabilities, it is called negative working capital (or net current liabilities). It may also be referred to as overtrading. That means the business is using much borrowings to carry out its business activities.
A firm must optimize its working capital. If a company decides to keep more working capital it may lose its profitability. However, if it uses its working capital to trade, it may result in profitability but the firm may not have enough to pay its current obligations.
The formula for calculation working capital is Current Assets – Current Liabilities.
The general rule is that current assets should double current liabilities. Anything less than that may affect the business ability to meet liabilities as it falls due. However, it depends on the industry the company belongs to.
Also, if it is more than double, it may lose its profitability. And it means that the business is not utilising its available capital to trade and meet customers demand. Therefore, an optimal net working capital is necessary.
In conclusion, net-working capital reveals the amount of capital available for the firm to meet its current liabilities as it falls due. It is also a guide to the financial manager to keep check its cash flow and profitability.