Net Working Capital is the difference between a company’s current (also called short-term) assets and current (short-term) liabilities. Very often, this indicator is shown as a ratio between these two items. Meaning how many times can a company pay off its current obligations using its current assets. If the quotient is higher than one, then the Net Working Capital is positive and vice-versa.
As mentioned above, the NWC is a measurement tool for the liquidity, operational efficiency and in general the short-term financial health of a company. Assessing the NWC level of a company in a three-step process gives a good picture of the company’s ability to meet short-term obligations:
1. Calculating the absolute level of NWC: a negative result (current liabilities > current assets) is often the first sign of financial distress. However, in some cases/sectors, a negative NWC can be normal
2. Comparing the NWC level of the company to its historical development: is an increase/decrease in line with revenue development? Has a new inventory management system been enabled to lower inventory levels? Has a diligent treasury department re-negotiated collection and payment terms? The answers to these types of questions can explain a significant change
3. Comparing the company’s NWC level to that of its competitors: the absolute NWC level should be re-based (e.g. relative to revenue) in order to account for size differences in the peer set and thus enable comparability. In general, a working capital level in line or higher than the industry average is considered positive, acceptable and desirable
After this three-step analysis, you should be able to assess whether the company has the potential to finance investments, further sales and growth or whether it is currently in a tight liquidity position (compared to its peers) – at least in the short term. Nevertheless, you should always consider not having an excessive NWC level in the long-term, because it could indicate that the company has too much inventory (cannot get rid of its products) and/or is not investing (or distributing) its excess cash. Low levels, below industry-average or sometimes even negative NWC can indicate liquidity issues and is usually to be avoided.
Although the actual definition of NWC differs from case-by-case, the following parts of NWC are in general included in the calculation:
- Current assets: all assets of a company that are expected to be turned liquid (=sold, consumed, used, exhausted) through the standard operations of the company within a year or normal business cycle. Flexibility regarding the expected timeline is important, as some companies tend to sell their products, services, inventories only after a longer period than 12 months, e.g.: customised ship manufacturers. Typically, the following items are categorised as current assets (varies on a company-by-company basis): accounts receivables, finished goods inventory, raw material inventory, prepaid expenses, etc.
- Current liabilities: all financial liabilities of a company that are due within a year or normal business cycle of the company. Again, not only the absolute term of the liability, but its character itself is important in determining whether the payment due has a short-term or long-term character. It is important to mention that both interest-bearing and non-interest-bearing financial obligations can be current liabilities (varies on a company-by-company basis): accounts payables, short-term debt, interest payable, dividends payable, deferred revenue (the short-term portion), income taxes owed, etc.
Net Working Capital in an M&A Deal
Almost every M&A transaction covers the topic of NWC. Each company to be acquired must have a certain level of NWC in order to ensure the going concern principle during/after the transaction. Therefore, a pre-determined working capital “target” is usually defined in the Letter of Intent (LOI) or the latest in the Share Purchase Agreement (SPA). This normalised level is agreed upon by the buyer and seller and is usually derived from historical figures (e.g. trailing 12 months) as an average since the NWC level fluctuates naturally. It is important to account for seasonality (if relevant), or the fact that the company is growing or shrinking.
Within the confines of a so-called Purchase Price Adjustment the difference between the actual level of NWC and the pre-determined target is paid by the buyer (if NWC actual > normalised) or the seller (if NWC actual < normalised). This mechanism aligns the interests of the two parties and creates transparency during transactions. Otherwise – if a normalised level is not defined – a seller might have the incentive to sell inventory and collect outstanding receivables (even at a discount) and take the cash out of the company before selling the shares of the company for an agreed fix price.
To summarize, you can say, that companies aim to have a positive Net Working Capital, in line with revenue development – if possible above the industry average. This reassures all business partners (suppliers, employees, banks, but also customers) and other stakeholders that the operations are running healthy, inventories are at an adequate level (smoothening out order fluctuations) and payment obligations will be settled in due time to guarantee the sustainable day-to-day operations of the company.