Net working capital is essential to optimise the production process and to keep operating activities continuous. Often due to improper management of the net working capital, small and medium businesses land into cash flow crisis. To remedy this, businesses often resort to external financing options like – loans, investments, factoring, etc.
- MSMEs account for more than 16% of lending from financial institutions. A sizable chunk of this financing goes towards working capital financing.
- Between March and April of 2020, financial institutions in India disbursed approximately Rs.5.66 lakh crore as loans to 41.81 lakh accounts.
However, the timely repayment of borrowed sum becomes an issue for a large segment of MSMEs if they continue to mismanage their operating capital and a long turnaround cycle, among other factors.
- According to data shared by TransUnion CIBIL in 2020, the MSME NPA rate stood at 18.7% in December 2019, which was higher than the commercial NPA rate of 17.3% in India. (3)
This indicates that businesses should be more cautious when it comes to their short-term capital management. To monitor it, businesses should be familiar with the concept and know how to compute it.
What is net working capital?
Net working capital is also known as working or operating capital. It is the difference between the current assets and current liabilities of a firm. Operating capital serves as an efficient measure of a firm’s immediate liquidity and the capability to meet immediate debt and liabilities without interrupting the flow of everyday activities. Typically, a positive net working capital indicates high liquidity and robust financial standing.
To ensure a business never goes out of working capital, it is essential to manage one’s accounts receivables and payables better and optimise the inflow and outflow of funds carefully.
Formula of net working capital – Calculation and example
The standard formula of operating capital is –
NWC = Accounts Receivable + Inventory – Accounts Payable
NWC = Current Assets – Current Liabilities
Suppose a company has short-term debt of Rs.20,000, cash and cash equivalents worth Rs.50,000, accounts receivable of Rs.5,000, accounts payable worth Rs.7,000, inventories of Rs.10,000 and accrued liabilities of Rs.3,000.
So as per formula,
NWC = Current Assets – Current Liabilities
= Rs.(65000 – 30000)
With the help of this formula, one can quickly compute the working capital requirement of a company, which would in turn, help to boost the same.
Ratio derivation from the operating capital
The net capital ratio is a financial measurement that helps to determine if a company has enough assets to meet its immediate liabilities. It is obtained by dividing the current assets of a firm by its current liabilities.
Its formula is –
(Current Assets) / (Current Liabilities)
Usually, a ratio between 1.2 and 2 is considered to be optimal. However, a ratio higher than that indicates that a firm is not using its current assets efficiently. The ratio comes in handy to manage short-term assets of a firm and helps to understand how much working capital a business needs to operate smoothly.
Tips to increase net working capital
By using these useful tips, one can easily increase their operating capital –
Selling long-term assets in exchange for cash
Businesses should consider selling unused or old assets that are not necessarily current assets. Selling them for cash will boost immediate cash flow and increase operating capital.
Change payment terms
To shorten the operating capital cycle, businesses should consider changing their payment terms. They can provide short repayment terms to buyers to receive funds quickly.
Through the issuance of preferred stocks or common stocks
Businesses can boost capital by issuing preferred stocks or common stocks. However, doing so, they will lose a share of company ownership to the shareholders.
Applying for a business loan
Another effective way of improving operating capital is by availing a long-term business loan from financial institutions like Bajaj Finserv that extend a high loan amount at an attractive rate of interest.
They also help customers with lucrative pre-approved offers to make the process of availing a financial product smooth. Mostly such loans accompany financial products like business loans and personal loans. Check your pre-approved offer online by entering your name and contact information.
One can say that by computing the operating capital of a firm, both entrepreneurs and potential investors can determine its financial standing and efficiency. Since net working capital is so essential, businesses must develop suitable strategies to manage it efficiently.