NWC: Definition and Measurement
Working capital, also referred to as net working capital (NWC), is an absolute measure of a company’s current operative capital employed and is defined as:
(Net) working capital = Current assets − Current liabilities
Current assets are assets which are expected to be sold or otherwise used within one fiscal year. Typically, current assets include cash, cash equivalents, accounts receivable, inventory, prepaid accounts which will be used within a year, and short-term investments.
Current liabilities are considered as liabilities of the business that are to be settled in cash within the fiscal year. Current liabilities include accounts payable for goods, services or supplies, short-term loans, long-term loans with maturity within one year, dividends and interest payable, or accrued liabilities such as accrued taxes.
Working capital, on the one hand, can be seen as a metric for evaluating a company’s operating liquidity. A positive working capital position indicates that a company can meet its short-term obligations. On the other hand, a company’s working capital position signals its operating efficiency. Comparably high working capital levels may indicate that too much money is tied up in the business.
The most important positions for effective working capital management are inventory, accounts receivable, and accounts payable. Depending on the industry and business, prepayments received from customers and prepayments paid to suppliers may also play an important role in the company’s cash flow. Excess cash and nonoperational items may be excluded from the calculation for better comparison.
As a measure for effective working capital management, therefore, another more operational metric definition applies:
(Operative) net working capital = Inventories + Receivables − Payables − Advances received + Advances made
receivables are trade receivables;
payables are non-interest-bearing trade payables;
advances received are prepayments received from customers;
advances made are prepayments paid to suppliers.
When measuring the effectiveness of working capital management, relative metrics (for example, coverage) are generally applied. They have the advantage of higher resistance to growth, seasonality, and deviations in (cost of) sales. In addition to better comparison over time, they also allow better benchmarking of operating efficiency with internal or external peers.
A frequently used measure for the effectiveness of working capital management is the so-called cash conversion cycle, or cash-to-cash cycle (CCC). It reflects the time (in days) it takes a company to get back one monetary unit spent in operations. The operative NWC positions are translated into “days outstanding”—the number of days during which cash is bound in inventory and receivables or financed by the suppliers in accounts payable. It is defined as follows:
CCC1 = DIO + DSO − DPO
days inventories outstanding (DIO) = (average inventories ÷ cumulative cost of sales) × 365 = average number of days that inventory is held;
days sales outstanding (DSO) = (average receivables ÷ cumulative sales) × 365 = average number of days until a company is paid by its customers;
days payables outstanding (DPO) = (average payables ÷ cumulative purchasing volume) × 365 = average number of days until a company pays its suppliers.
Optimizing the three components of operative NWC simultaneously not only accelerates the CCC, but also goes hand in hand with further improvements. Figure 1 illustrates how an NWC optimization impacts the value added and free cash flow of a company. However, applying the right measures will not only increase value added by lowering capital employed. Improved processes will also lead to reduced costs and higher earnings before income and taxes (EBIT).