What does increasing nwc mean?

The net working capital metric is a measure of liquidity that helps determine whether a company can pay off its current liabilities with its current assets on hand.

As a general rule, the more current assets a company has on its balance sheet in relation to its current liabilities, the lower its liquidity risk (and the better off it’ll be).

While certain accounting textbooks will define the change in net working capital as current assets minus current liabilities, the more practical formula excludes cash and short-term investments like marketable securities and commercial paper, as well as any interest-bearing debt such as loans and bonds.

The reason is that cash and debt are both non-operational and do not directly generate revenue.

In fact, cash and cash equivalents are more related to investing activities because the company could benefit from interest income, while debt and debt-like instruments would fall into the financing activities.

Since we have defined net working capital, we can now explain the importance of understanding the changes in net working capital (NWC).

On the cash flow statement, the changes in NWC are essential because tracking these changes over time (e.g. year-over-year or quarter-over-quarter) helps assess the degree to which a company’s free cash flows are going to deviate from its accrual-based net income (“bottom line”).

The formula for the change in net working capital (NWC) subtracts the current period NWC balance from the prior period NWC balance.

As a sanity check, you should confirm that if the NWC is growing year-over-year, the change should be reflected as a negative (cash outflow), and the change would be positive (cash inflow) if the NWC is declining year-over-year.

The screenshot below is of Apple’s cash flow statement, where the highlighted rows capture the change in Apple’s working capital assets and working capital liabilities.

Screenshot from Apple 3-Statement Model (Source: WSP Premium Package)

If a company’s change in NWC has increased year-over-year (YoY), this implies that either its operating assets have grown and/or its operating liabilities have declined from the preceding period.

An increase in the balance of an operating asset represents an outflow of cash – however, an increase in an operating liability represents an inflow of cash (and vice versa).

When calculating free cash flow, whether it be on an unlevered FCF or levered FCF basis, an increase in the change in NWC is subtracted from the cash flow amount.

But if the change in NWC is negative, the net effect from the two negative signs is that the amount is added to the cash flow amount.

For instance, let’s say that a company’s accounts receivables (A/R) balance has increased YoY while its accounts payable (A/P) balance has increased as well under the same time span.

The net effect is that more customers have paid using credit as the form of payment, rather than cash, which reduces the liquidity (i.e. cash on hand) of the company.

As for payables, the increase was likely caused by delayed payments to suppliers. Even though the payments will someday be required to be issued, the cash is in the possession of the company for the time being, which increases its liquidity.

Therefore, a positive change in net working capital implies reduced cash flow for a company, whereas a negative change in net working capital means the opposite, an increase in cash flow.

In the absence of further contextual details, negative net working capital (NWC) is not necessarily a concerning sign about the financial health of a company.

For instance, if NWC is negative due to the efficient collection of receivables from customers that paid on credit, quick inventory turnover, or the delay of supplier/vendor payments, that could be a positive sign.

However, negative working capital could also be a sign of worsening liquidity caused by the mismanagement of cash (e.g. upcoming supplier payments, inability to collect credit purchases, slow inventory turnover). In such circumstances, the company is in a troubling situation related to its working capital.

We’ll now move to a modeling exercise, which you can access by filling out the form below.

In our hypothetical scenario, we’re looking at a company with the following balance sheet data (Year 0).

Financial Assumptions (Year 0)

Given those figures, we can calculate the net working capital (NWC) for Year 0 as $15mm.

As for the rest of the forecast, we’ll be using the following assumptions for each projected year:

Once the remaining years are populated with the stated numbers, we can calculate the change in NWC across the entire forecast.

Since the growth in operating liabilities is outpacing the growth in operating assets, we’d reasonably expect the change in NWC to be positive.

If a company has very high net working capital, it generally has the financial resources to meet all of its short-term financial obligations. Broadly speaking, the higher a company's working capital is, the more efficiently it functions.

Net working capital (NWC) and changes in NWC throughout the years play crucial roles for businesses. Positive or negative changes in the net working capital indicate the difference between the NWC of any two periods (months, quarters, current and previous years).

Accountants should track changes since they provide business management with valuable insight. Let us take a closer look at NWC and how to calculate changes.

A net working capital (or NWC) is the difference between the business’s current assets, such as cash, accounts receivables, inventories, etc., and its current liabilities, such as accounts payable, debts, etc.

The net working capital measures a business’s liquidity, its short-term financial health, and operational efficiency. If the company has a positive net working capital, it can invest it to improve the business.

But if a business’s liabilities exceed the current assets, then it’s a possible sign of difficulties to pay back creditors. The company may even go bankrupt if the current assets don’t exceed liabilities.

In accounting, the “Change in NWC” section of the cash flow statement tracks the net change in operating assets and liabilities during a specific period. Typically, two periods are compared — previous and current years.

A business owner needs total current assets and total current liabilities for the current and previous years to calculate the change in NWC. The higher the total number of current assets or the lower the total current liabilities, the higher NWC.

An increase or decrease of NWC isn’t always bad or good. In some cases, the decrease may be caused by increased liabilities since the company acquired a debt to optimize business processes. Eventually, it will bring positive effects, but only if the company keeps track of changes.

An increase in NWC may be bad if the company doesn’t have cash even though current assets increased while liabilities decreased. The change may reduce the company’s liquidity, or the company isn’t making any investments in business optimization.

That’s why business owners should keep track of changes in NWC to understand their situation. If a company asked for a credit to invest in business processes, but there are no positive changes next year, it could be a problem. But detecting the problem gives business owners a chance to rearrange a business plan and introduce improvements.

The formula to calculate the change in the net working capital is as follows:

Net working capital for the current period – net working capital for the previous period = change in net working capital.

To calculate the change, you need to determine the net working capital for both the current and previous period, and here’s the formula:

Current assets – current liabilities = net working capital.

In this article, you will find a comprehensive guide on calculating the change in NWC, current assets, liabilities, etc.

Make the process of calculating the change in NWC simpler by breaking the process into four phases as in the example:

Now let’s dive into the details!

The first important step is to determine the current assets of the current year and previous year (2021 and 2022). A current asset is a property that a business can easily convert into cash within one year. Here are some examples of current assets:

Determine all company’s current assets and add them up to get a total. Let’s assume the company has $805,000 and $890,000 in current assets (2021 and 2022, respectively).

The next step is determining total liabilities (current and previous years). Here are some of the examples of current liabilities:

Determine what current liabilities a company has and add them to get a total amount. Let’s say the business has $700,000 and $650,000 in current assets (2021 and 2022, respectively).

The working capital formula is as follows:

Current assets – current liabilities = working capital

Now that you know both numbers for 2021 and 2022, it’s easy to determine the working capital.

The last step is to determine the change in working capital by using the formula. Subtract the previous year’s working capital from the current year’s working capital according to the calculations made above in the table.

$240,000 (2022) – $105,000 (2021) = $135,000.

So, the change in NWC is $135,000.

If a business’s change in net working capital increases year-over-year, there are two possible explanations. The company’s operating assets have increased, or their liabilities have declined during the year. It’s also possible that these situations occur at the same time.

If the balance increases because of the increase of current operating assets, then the situation represents an outflow of cash. If there is an increase in an operating liability, then the situation reflects an inflow of cash and vice versa.

Let’s assume the business’s accounts receivables (A/R) balance increased year-over-year, but its accounts payable (A/P) balance has also increased during the same period.

What net effect does this situation have for the business? More customers used credit as a form of payment, not cash. The absence of cash reduces the company’s liquidity.

The increase in the A/P balance occurred because of the delayed payments to the suppliers — the most common situation. Even though the payments will be eventually issued, the cash is still in possession of the company on paper. As a result, it increases the company’s liquidity.

So, the positive change in NWC reflects reduced cash flow, while the negative change implies the opposite and an increase in cash flow which is good for the company.

Let’s take the example from the previous section of the article. The company has a positive change in net working capital. One would assume it’s a good sign since the company has fewer liabilities and more current assets. Even though a lowered number of liabilities is a good sign, the company might have a problem with cash flow which reduces its liquidity.

On the other hand, if the company transforms its account receivable to cash and invests in the company’s growth, the positive change is a good sign. So, high NWC isn’t necessarily a bad or good thing for the company, and it depends on each individual situation.

Accountants can consider taking courses (free or paid) to offer valuable data to their employers. As mentioned, negative and positive changes in NWC can be interpreted differently, and it’s critical to understand how to read these changes.