As a business owner, it is important to know the difference between working capital and changes in working capital. Working capital tells you the level of assets your business has available to meet its short-term obligations at a given moment in time. Change in working capital, on the other hand, measures what is happening over a given period of time with regard to the liquidity of your company.
Changes in working capital are often used by investors and lenders to assess the health and value of a business. Read on to learn what causes a change in working capital, how to to calculate changes in working capital, and what these changes can tell you about your business.
Key Points
• Net working capital (NWC) is the difference between a company’s current assets and current liabilities.
• A positive NWC means a company can pay off its debts and invest in growth. Negative NWC suggests potential liquidity issues, requiring more external financing.
• To find the change in net working capital, subtract the net working capital of the previous year from the net working capital of the current year.
• Changes impact a company’s need for external financing for operations or expansion.
• External financing options include angel investors, small business grants, crowdfunding, and small business loans.
What Is Net Working Capital?
Net working capital is simply another name for working capital. It is a basic accounting formula companies use to determine their short-term financial health. The basic formula is:
Current Assets – Current Liabilities = Net Working Capital (or Working Capital)
What Is Change in Net Working Capital?
Change in net working capital refers to how a company’s net working capital fluctuates year-over-year. If your net working capital one year was $50,000 and the next year it was $75,000, you would have a positive net working capital change of $25,000.
What Is Working Capital?
Working capital is a company’s current assets minus its current liabilities. Both current assets and current liabilities are found on a company’s balance sheet.
Current assets include assets a company will use in fewer than 12 months in its business operations, such as cash, accounts receivable, and inventories of raw materials and finished goods. Current liabilities include accounts payable, trade credit, short-terms loans, and business lines of credit. Essentially, working capital is the amount of money a company has available to pay its short-term expenses.
Positive Working Capital
A business has positive working capital when it currently has more current assets than current liabilities. This is a sign of financial health, since it means the company will be able to fully cover its short-term obligations as they come due over the next year.
It’s possible to have too much of a good thing, however. Excessive working capital for a prolonged period of time can mean a company is not effectively managing its assets.
Recommended: Net Operating Working Capital (NOWC), Explained
Negative Working Capital
A business has negative working capital when it currently has more liabilities than assets. This can be a temporary situation, such as when a company makes a large payment to a vendor. However, if working capital stays negative for an extended period, it can indicate that the company is struggling to make ends meet and may need to borrow money or take out a working capital loan.
Working Capital Ratio
Another way to measure working capital is to look at the working capital ratio, which is current assets divided by current liabilities. Generally, a working capital ratio of less than 1.0 is an indicator of liquidity problems, while a ratio higher than 2.0 indicates good liquidity.
What Causes Changes in Working Capital?
There are a number of factors that can cause a change in working capital. These include:
Credit Policy
Credit policy adjustments often lead to changes in how quickly cash comes in. A tighter, stricter policy reduces accounts receivable and, in turn, frees up cash. That comes at a potential cost of lower net sales since buyers may shy away from a firm that has highly strict credit policies. Looser credit policies can have the opposite effect. As with many of these factors, there is a tradeoff to weigh.
Accounts Payable Payment Period
Negotiating a longer accounts payable period with your suppliers frees up cash because you have more time to pay your bills.The downside is that a supplier might increase prices in response to allowing a longer payment period. Shortening your accounts payable period can have the opposite effect, so business owners will want to carefully manage this policy.
Collection Policy
A company’s collection policy is a written document that includes the protocol for tackling owed debts. If you’re seeking to increase liquidity, a stricter collection policy could help. Cash comes in sooner (and total accounts receivable shrinks) when there is a short window within which customers can hold off on paying. A less aggressive collection policy has the opposite impact.
Growth Rate
Stronger growth calls for greater investment in accounts receivable and inventory, which uses up cash. This, in turn, can lead to major changes in working capital from one month to the next. A slower growth rate can reduce changes in net working capital.
Inventory Planning
Inventory decisions are a crucial factor that can lead to a change in working capital. If a company chooses to spend more on inventory to increase its fulfillment rate, it will use up more cash. Reducing inventory could free up cash to be used on other business expenses.
Purchasing Practices
A change in purchasing practices can also lead to changes in working capital. If the purchasing department opts to buy larger quantities at one time, it can lower unit prices. However, it means a higher outlay of cash. Buying in smaller amounts can have the opposite effect.
Hedging
Using hedging strategies to offset swings in cash flow can mitigate unexpected changes in working capital. However, there are some costs involved in these hedging transactions, which could affect cash flow.
Recommended: Variable Costing Income Statements
Formula for Calculating Change in Working Capital
The change in working capital formula is straightforward once you know your balance sheet. Simply take current assets and subtract current liabilities. That difference is your working capital (WC).
Next, compare the firm’s working capital in the current period and subtract the working capital amount from the previous period. That difference is the change in working capital.
Change in WC = Current year WC – Last year WC
As an example, let’s say in 2023 your working capital was $75,000. In 2022, your working capital was $50,000. Using the formula above, we have:
Change in WC = $75,000 – $50,000 = $25,000
You can then use this figure to better understand your company’s health. If your firm experiences a positive change in net working capital, it may have more cash to invest in growth opportunities or repay debt. If it experiences a negative change, on the other hand, it can indicate that your company is struggling to meet its short-term obligations.
Why Calculating Changes in Working Capital Is Important
As a small business owner, monitoring and understanding changes in working capital over time, whether it’s quarter-over-quarter or year-over-year, can help you better understand your company’s cash flow.
Working capital is also important if you are trying to woo an investor or get approved for a small business loan. Lenders and investors will often look at both working capital and changes in working capital to assess a company’s financial health. Wide swings from positive to negative working capital can offer clues about a company’s business practices. A business owner can often access more attractive small business loan rates and terms when the firm has a consistent working capital policy.
Recommended: 15 Types of Business Loans to Consider
What Impacts Can Various Changes in Working Capital Have?
Change in working capital is the change in the net working capital of the company from one accounting period to the next. This will happen when either current assets or current liabilities increase or decrease in value.
Change in net working capital is an important indicator of a company’s financial performance and liquidity over time. By calculating the change in working capital, you can better understand your company’s capital cycle and strategize ways to reduce it, either by collecting receivables sooner or, possibly, by delaying accounts payable.
Understanding changes in cash flow is also important if you are applying for a small business loan. Lenders will often look closely at a potential borrower’s working capital and change in working capital from quarter-to-quarter or year-to-year.
Positive Impacts
If the change in working capital is positive, then you have more assets than liabilities. This means the company’s liquidity is increasing.
Negative Impacts
If the change in working capital is negative, it means that the change in the current operating liabilities has increased more than the current operating assets. Cash has been used, and this reduces liquidity.
The Takeaway
Working capital is a basic accounting formula (current assets minus current liabilities) business owners use to determine their short-term financial health. Changes in working capital can occur when either current assets or current liabilities increase or decrease in value.
As a business owner, it’s important to calculate working capital and changes in working capital from one accounting period to another to clearly assess your company’s operational efficiency. This is especially important if you are in the market for financing. Lenders will often look at changes in working capital when assessing a company’s management style and operational efficiency.
If you’re seeking financing for your business, SoFi is here to support you. On SoFi’s marketplace, you can shop and compare financing options for your business in minutes.
FAQ
How is change in working capital calculated?
To calculate change in working capital, you first subtract the company’s current liabilities from the company’s current assets to get current working capital. You then take last year’s working capital number and subtract it from this year’s working capital to get change in working capital.
What are some things that can affect working capital?
Items affecting working capital include any changes in current assets and current liabilities. Current assets include cash (and cash equivalents), marketable securities, inventory, accounts receivable, and prepaid expenses. Current liabilities include accounts payable, short-term debt (and the current portion of long-term debt), dividends payable, current deferred revenue liability, and income tax owed within the next year.
What changes in working capital impact cash flow?
Any change in working capital can affect cash flow, which is the net amount of cash and cash equivalents being transferred in and out of a company. If the change in working capital is negative, it reduces cash flow. If the change in working capital is positive, it increases cash flow.
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