A company needs capital to be able to operate its business. There are many sources of capital, such as cash and assets. But what does Net Operating Working Capital mean?
The Net Operating Working Capital of a company is its operating current assets minus its operating current liabilities. In the majority of the cases, NOWC equals cash plus accounts receivables plus inventories minus accounts payable minus accrued expenses.
To put the idea in a clearer and easier way to understand, NOWC refers to a financial metric that measures the capability of a business to pay off its operational liabilities or expenses with its operational assets.
Read on to learn more about the meaning of Net Operating Working Capital, its difference with Total Operating Capital and Working Capital, and how to calculate it.
Net Operating Working Capital
A company’s net operating working capital or NOWC refers to its operating current assets minus its current liabilities. In many cases, it is cash plus accounts receivables plus inventories minus accounts payable minus accrued expenses.
The NOWC of a company is its financial metric that measures its operating liquidity by comparing its operating assets with its operating liabilities. As such, it is a financial metric that determines the ability of the company to pay off its operational liabilities with its operational assets.
You should now confuse NOWC with the company’s net working capital (NWC). These two are different. Net working capital (NWC) is the sum of all its assets minus all its outstanding liabilities. Basically, operating working capital is all the company assets minus cash and securities, minus all short-term and non-interest debts.
More Detailed Information about Net Operating Working Capital
NOWC is a figure showing the liquidity of a business entity. It is an important metric for a company because it determines its leverage in procuring investments and its current working assets. It will show if the company can pay off all of its working liabilities with its operational assets.
A company’s net operating working capital will also show how it operates using its resources and efficiently adapt to unexpected events and opportunities. You can easily understand this by looking at the NOWC formula:
(Cash + Accounts Receivable + Inventory) – (Accounts Payable + Accrued Expenses)
A definition of terms can be useful at this point:
Operating Current Assets
What are operating current assets? These are assets required to support the company’s operation and assets expected to be converted into cash in the next 12 months. Current financial investments are not included in these types of assets.
Operating Current Liabilities
What are operating current liabilities? These are liabilities undertaken to continue the company’s operation, and they are expected to be settled within the next 12 months. They do not include interest-bearing liabilities or current loans.
That is why net operating capital is not to be confused with net working capital. NWC is simply the result when you subtract current liabilities from the current assets. NOWC, on the other hand, is an intermediate or interim input in the computation of free cash flow. The keyword here is ‘operating,’ meaning it is more current.
Free Cash Flow
Free cash flow is defined as the operating cash flow minus gross investment in operating assets minus investment in net working capital.
Another way to define NOWC is the financial metric that estimates the difference between the non-interest-bearing operating assets of a company and its non-interest charging operating liabilities.
Liquidity Ratio
The result that you’ll get in the calculation is the company’s liquidity ratio that shows how it can pay off its current operation liabilities with its current operational assets. It reveals the amount of leverage that the company has together with its net operating assets.
Another Definition of NOWC
Another definition of NOWC is it is a direct measure of the company’s operational efficiency, liquidity, and overall financial health – in the short term. Businesses with a big amount of NOWC against their accruals and liabilities show that they can make investments if required and grow over time.
But if a company’s net operating working liabilities exceed its capital, it could show that it is in financial trouble to some degree. In such cases, the ratio of the working capital is usually less than one.
NOWC Above a Specific Amount
With one as a breakeven point, a positive working capital indicator will always be more than one. However, a NOWC above a specific amount can be regarded as too high by some analysts.
This may indicate that the company is not correctly investing its expendable cash or carries an excess amount of inventory. In an ideal situation, the NOWC ratio of a business should at least be two-to-one. In this situation, some padding is built into the company’s cash flow.
You also need to understand that NOWC does not take into account either human or natural capital. This practice allows businesses to overlook their inefficiencies in using their natural or human resources. They want to be able to evaluate their performance just by the numbers that appear on their books.
By this approach, investors can make apple-to-apple comparisons between the cash flows of two companies without considering the human aspect of their operations. So, NOWC is important to know when evaluating the balance sheet and cash flow of a company.
In general, a company’s net operating working capital is equal to its cash, inventories, and accounts receivables, minus accruals and accounts payables. Human and natural capital are not included in the calculations. With this practice, companies can disregard inefficiencies in these assets when evaluating their performances.
Differences Between Net Operating Working Capital, Total Operating Capital, and Working Capital
As a backgrounder: businesses use their financial statements to assess their financial and operational health. A typical company’s balance sheet is designed to show investors, business owners, and managers certain insights regarding asset quality, profit reinvestments, and leverage.
In this regard, two variables are calculated from figures indicated on the balance sheet, which helps them see the operational and financial health of the business and its growth potential. These two variables are the Total Operating Capital (TOC) and the Net Operating Working Capital (NOWC).
So, capital can be categorized in several ways. It can be TOC or total operating capital, WC or working capital, and NOWC or net operating working capital.
Total Operating Capital
Total operating capital or TOC is the total amount of assets, including short and long-term assets that remain after current liabilities that arise from operations are deducted. This is the capital that is required by a business to sustain its operations.
The main difference between TOC and NOWC is comparing the United States with just one state alone. For instance, California is only one of the 51 states that comprise the United States of America.
So, total operating capital is the whole, and net operating working capital is just a part of the whole. TOC is composed of NWOC and other fixed assets of the company.
TOC Shows the Big Picture
The focus of TOC is both on the short-term and the long-term, while NOWC is more focused on the short-term. TOC encompasses every asset of the company, including those of the NOWC and its fixed assets. The fixed assets of a business include the following:
- Land
- Buildings
- Machinery
- Equipment
- Office furniture
- Vehicles owned by the company
Working Capital
Working capital (WC) will give you a broader view of the company’s finances than NOWC. Net operating working capital is just a subset of WC. It is the current assets minus current liabilities.
Short-term or current assets include cash, receivables, and inventory, just the same way as NOWC. But this also includes other bills and rent the company paid in advance, work-in-process, and raw materials.
Current liabilities include accruals and accounts payable, just like with NOWC. But it also includes current portions of long-term debt, lines of credit, and customer deposits.
Net working capital or NWC is the difference between the current assets and current liabilities of a company. If the NWC of a company is positive, it means the company has enough funds to satisfy its current financial obligations.
How NOWC Differs
Basically, NOWC can be considered as operating capital. It takes the company’s current assets and then subtracts its short-term liabilities. What constitutes current assets? They are the following:
- Cash
- Accounts Receivables
- Inventory
Short-term liabilities consist of accruals (e.g., employee bonuses) and accounts payable. As soon as you have deducted all the liabilities from the assets, the result is the NOWC. Ideally, NOWC should be greater than liabilities.
Relation Between TOC and NOWC
To help you better understand TOC and NOWC, here are some sample calculations of a business that show their relationship.
The short-term assets of a business include the following:
- Cash – $150,000
- Accounts receivables – $250,000
- Inventory – $150,000
- Total short-term assets – $550,000
The total liabilities of the company are the following:
- Accounts payable – $70,000
- Accruals – $ 50,000
- Total liabilities – $120,000
Calculate Total Net Operating Working Capital
To calculate the total net operating working capital (NOWC):
Subtract the total liabilities from the total short-term assets. So, the amount will be:
$550,000 – $120,000 = $430,000.
If we assume that the long-term assets of the company are about $700,000. To get its total operating capital (TOC), you need to add its NOWC with its long-term assets. So, the TOC amount will be:
$430,000 + $700,000 = $1,130,000
So, as you can see, TOC has two components: its long-term assets and its short-term assets. NOWC is the short-term component, and the long-term asset is the long-term component.
Why are these two terms more important than the others? Some lenders and investors prefer to use NOWC and TOC more than other broader definitions of working capital and capital because of their focus on ‘operations.’
Companies tend to inflate the numbers in their asset column in borrowing money or convincing investors to invest. But investors and lenders measure the liquidity of a business operation by their working capital. That is why they focus more on operating assets. In their eyes, they are the more credible measures of a company’s viability.
Again, a company’s Net Operating Working Capital (NOWC) refers to its current assets less the company’s operating current liabilities. Usually, NOWC is equal to a company’s total cash, accounts receivable, and inventories minus its accounts payable and accrued expenses.
Calculating Net Operating Working Capital
We come now to the practical application of what we have discussed above. Let me show you how to calculate net operating working capital.
Basic Formula
Net Operating Working Capital = Current Operating Assets – Current Operating Liabilities
More Detailed Formula
A more detailed and specific formula used by investors goes this way:
Net Operating Working Capital = (Cash + Accounts Receivable + Investments) – (Accounts Payable + Accrued Expenses)
Example
Here is an example on how to use this formula to calculate NOWC of a company.
The assets of Tool Company show the following figures on its balance sheet:
- Cash – $150,000
- Accounts Receivable – $30,000
- Inventory – $550,000
The liabilities of Toy Company are as follows:
- Accounts Payable – $350,000
- Accrued Expenses – $150,000
Using the formula to get the NOWC of Toy Company:
($150,000 +30,000 + $550,000) – ($350,000 + $150,000) =
$730,000 – $500,000 = $230,000
With $230,000 as its NOWC, it will be easy for Tool Company to pay off all its working liabilities with just a portion of its working assets. If its lenders simultaneously call all its debts, the company will still pay them off.
The company will still have enough of its working assets to keep on operating. Lenders and investors will know that this company is financially healthy and have no liquidity problems. If it asks for more investment, they will gladly provide the money since it is low investment risk.
Conclusion: Net Operating Working Capital
A company’s Net Operating Working Capital is its operating current assets minus its operating current liabilities. Typically, NOWC is the amount or figure you will get by adding the accounts receivables to the inventories. And then, you need to subtract the accounts payable and the accrued expenses from the total operating current assets.
The NOWC of a company is an important metric to potential investors. It shows lenders if the company is financially healthy and has no liquidity problems.
