Changes in Net Working Capital

Change in the net working capital is the difference between available funds and outstanding payments of the company in an accounting period when compared with other accounting periods, which is calculated to make sure that sufficient working capital is maintained by the company in every accounting period so that there should not be any shortage or underutilization of funds.

The essence of the concept is that if a company has a positive working capital, it means they have funds in surplus. The inverse of having a negative working capital indicates that the company owes more than it has in its cash flow. It acts as the company’s metric for liquidity.

• Change in net working capital refers to the difference in a company's net working capital between two accounting periods.
• It is assessed to ensure that the company has sufficient working capital to sustain its operations in the future.
• If the increase in current assets and liabilities is proportional, then there will be no change in net working capital.
• A positive net working capital change occurs when current liabilities increase more than current assets, while a negative net working capital change occurs when current assets increase more than current liabilities.

Change in net working capital refers to the differences in the liquidity of the company. As in, it is a measure of if the company will be able to pay off its current liabilities with the assets in hand.

If the Net Working capital increases, we can conclude that the company's liquidity is increasing. It could indicate that the company can utilize its existing resources better. Some companies have negative working capital, and some have positive, as we have seen in the above two examples of Microsoft and Walmart. Generally, companies like Walmart, which have to maintain a large inventory, have negative working capital.

Software companies generally tend to have a positive change in working capital cash flow because they do not have to maintain an inventory before selling the product. It means that it can generate revenue without increasing current liabilities. Cash flow cannot increase with only a change in working capital. But if it is not sufficient, the company’s efficiency is greatly reduced.

• If the current assets and current liabilities have increased by the same amount, there would be no change in net working capital.
• If the change is positive, then the change in current liabilities has increased more than the current assets.
• If the change is negative, the change in the current assets has increased more than the current liabilities.

Let us understand the formula that shall act as a basis for us to understand the intricacies of the concept and its related factors.

Changes in Net Working Capital = Working Capital (Current Year) - Working Capital (Previous Year)

Or

Change in a Net Working Capital = Change in Current Assets - Change in Current Liabilities.

Now that we understand the basics and the formula of the concept, let us understand how to calculate the changes in net working capital cash flow through the step-by-step explanation below.

Below is the Snapshot of Colgate's 2016 and 2015 balance sheets. This example shall give us a practical outlook of the concept and its ebbs and flows.

Let us calculate the Working Capital for Colgate.

Working Capital (2016)

• Current Assets (2016) = 4,338
• Current Liabilities (2016) = 3,305
• Working Capital (2016) = 4,338 – 3,305 = $ 1,033 million

Working Capital (2015)

• Current Assets (2015) = 4,384
• Current Liabilities (2015) = 3,534
• Working Capital (2015) = 4,384 – 3,534 = $850 million

Net change in Working Capital = 1033 - 850 = $183 million (cash outflow)

Change in Working capital cash flow means an actual change in value year over year, i.e., the change in current assets minus the change in current liabilities. With the change in value, we will understand why the working capital has increased or decreased.

Below are a number of actions that will cause a change in Net Working capital:

1. If the company does not allow outstanding credit, the account receivables will get reduced. But sales may have a declining effect. Below are several actions that will cause a change in Net Working capital:
2. Inventory planning also impacts the change in working capital. An increase in inventory increases the usage of cash.
3. Stretching accounts payable impacts the change in working capital.
4. If the company's growth rate is high, it uses the cash more to buy inventories and increase account receivables. Cash will be heavily used for it then.

It is an indicator of operating cash flow, and it is recorded on the statement of cash flows. And the cash flow is one of the important factors to be considered when we value a company. It indicates whether the short-term assets increase or decrease concerning the short-term liabilities from one year to the next.

This has been a guide to what is Changes in Net Working Capital. Here we explain its meaning, formula, and how to calculate along with examples. You may also have a look at the related articles:

• Change in Net Working Capital (NWC) Formula
• Calculate Net Working Capital
• Fixed Capital vs. Working Capital Differences
• Calculate Working Capital Ratio