Net Working Capital

Net working capital is the difference between current (short-term) assets and current (short-term) liabilities. Current assets typically include cash, marketable securities, accounts receivable, inventory, and other assets that can be converted to cash in one year or less. Current liabilities typically include accounts payable, the current portion of notes payable or other long-term debt, and accrued expenses payable. Working capital is the amount of money required by a company to manage differences between cash inflows and outflows. It covers the cash conversion cycle in a business from raw materials to collections on accounts receivable. Internal sources of funds for net working capital are retained earnings, savings from efficiencies, and generated cash.1 Uses of net working capital include buying fixed assets, dividend payments, payment of long-term debt, and stock repurchases.2

The amount of optimal working capital varies by company, country, risk aversion, and industry. Net working capital can be beneficial to an extent, because a certain amount is usually required to cover expenses incurred in the firm's operating cycle. If a firm has high net working capital, that firm is less likely to fail in the short term, because it should be able to cover liabilities that it will incur in one year or less. Thus, the greater a corporation's net working capital, the better from a pure liquidity standpoint.3 However, large amounts of short-term assets can indicate that the company is not managing funds well, because a greater return can generally be realized with longer-term investments. For example, increasing receivables are not always beneficial, because this may indicate that the company has inefficient collections policies. Likewise, increasing inventory may indicate obsolescence. Many companies that are either growing or experience a seasonal business often need to obtain cash from outside sources to finance working capital needs. This short-term funding can be obtained using commercial paper, lines of credit, short-term loans, and asset-based borrowing, including asset securitization.4

Fluctuations in net working capital can result from projects that affect current assets and current liabilities. Inventories typically comprise a small portion of project investment for health care providers, so the net working capital changes that result can often be overlooked without adversely or noticeably affecting the project analysis.5 Whenever a capital project involves a significant positive change in net working capital (the increase in current assets exceeds the increase in current liabilities), the net investment in current assets and thus net working capital must be considered, to avoid overstating overall project profitability.6

Working capital management is significant to both lenders and investors. First, the amount of working capital required can have a strong effect on a company's cash flows and ability to repay debt. In addition, reducing working capital can increase a stock's price.7 A lower required working capital policy allows a company to distribute more cash to investors.