Home Finance What is Net Working Capital? Importance in Business Analysis

What is Net Working Capital? Importance in Business Analysis

MSMEs are considered the backbone of a developing economy like India. The said sector is responsible for generating over 45% of the county’s industrial employment. Regardless, MSMEs are enterprises with a limited amount of working capital.

Hence, to optimise production and to sustain profitability, MSME owners need to identify the importance of net working capital and devise ways to replenish it.

What is net working capital?

Net working capital can be defined as the amount of available cash and current assets that are left with a business owner after they have covered their operational liabilities.

Typically, networking capital enables business owners to invest in activities, which facilitate expansion and maintenance of business operations.

It is also expressed as the difference between an enterprise’s current assets and current liabilities.

The following pointers highlight some of the common sources of working capital for a business enterprise –

  1. Operational funds
  2. Sale of non-current assets
  • Tangible and intangible assets
  1. Long term borrowings like a working capital loan
  2. Issuance of equity and preference shares

Business analysis and net working capital

Net working capital is usually used as a financial metric by business owners and investors. It enables them to measure the financial standing of a firm and offers a fair idea of its operating liquidity and cash availability.

Additionally, it helps business owners to analyse how much working capital their business needs to operate smoothly.

The following pointers highlight the other roles of networking capital in business analysis –

  1. Helps to measure a firm’s short-term liquidity
  2. Indicates a firm’s efficiency to manage and use assets optimally.
  • Enables to determine the potential of a firm to expand its scale of operation
  1. Allows the investor to gauge the merit of a firm as an investment avenue

Notably, both business owners and investors use the working capital turnover ratio to gauge the proficiency of a company by using its available working capital. The said ratio is defined as annual net sales by working capital and is expressed as –

Working capital turnover ratio = Sales / Working capital

However, to use the said accounting ratio effectively, it is important to know how to compute the net working capital of a firm.

Calculation of net working capital

One can compute net working capital by using this formula,

Net working capital = Current assets – Current liabilities or,

Net working capital = Cash and cash equivalents + inventory + trade accounts receivable + marketable investments – trade accounts payable

If the value of net working capital is positive – it indicates that an enterprise has short-term liquidity to pay off immediate financial obligations and for expansion.

Alternatively, if the working capital is zero, it would indicate that the enterprise is only capable of paying off its immediate financial obligations.

On the other hand, a negative value indicates that the enterprise needs to raise money to maintain solvency.

In case business owners find it challenging to raise the capital, they can avail a business loan from financial institutions like Bajaj Finserv at a reasonable rate of interest and flexible tenor.

They also extend pre-approved offers to their customers, which would further make the process of availing funds convenient and quick.

Nevertheless, individuals must calculate the working capital requirements for their business before availing a working capital loan or raising funds to meet working capital requirement.

Also, certain things must be factored in before opting for a particular working capital financing option.

For instance, business owners should check –

  1. Amount of loan value
  2. Rate of interest
  • Repayment options
  1. The flexibility of tenor
  2. Collateral security requirement

Notably, net working capital comes in handy for both business owner and investor for accurate business analysis.

 In retrospect, business owners, especially MSMEs, should make it a point to maintain and use their net working capital efficiently to keep their everyday operations afloat. Simultaneously, they should choose a suitable funding option to meet their working capital requirement.

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