What Is a Net Operating Cost?

Net working capital is the balance of a company's total current assets minus various current liabilities . The amount of current assets reflecting the financing of long-term liabilities. As the long-term capital investment project inevitably involves the increase of short-term assets such as accounts receivable and inventory, the investment in such assets at the end of the project can be recovered. Therefore, when estimating the cash flow of each period, this part of the investment for new current assets must be considered, so as to more objectively reflect the cash flow of the project. ^[1]

Net working capital

Net working capital = current assets-current liabilities

As the net working capital is considered as a source of funds for the company's investment in non-current assets and for the settlement of non-current liabilities, the net working capital is mainly used to study the company's solvency and

It can be seen from the formula that the more net working capital is, the more secure the debt repayment is. Whether a company can repay short-term debt depends on how much debt it has and how much liquid assets it can use to repay its debt. When the current assets are greater than the current liabilities, the net working capital is positive, indicating a surplus in the net working capital. At this time, the current assets corresponding to the net working capital use a certain amount of non-current liabilities or owner's equity as the source of funds, indicating that the risk of insolvency is relatively small. Conversely, when the current assets are less than the current liabilities, the net working capital is negative, indicating a shortage of net working capital. At this time, some non-current assets of the enterprise use current liabilities as the source of funds, and the risk of the company's inability to pay debts is very high.

Net working capital rationality

The rationality of net working capital refers to the appropriate amount of net working capital. Short-term creditors want as much net working capital as possible, which will reduce loan risk. Because of the shortage of net working capital, companies will be forced to make unfavorable loans at inappropriate times and at unfavorable rates in order to maintain normal operations and credit, which will affect the ability to pay interest and dividends. But holding too much net working capital is not a good thing either. Because high net working capital means that there are more current assets and less current liabilities, and a large amount of idle funds will not generate more economic benefits. It also indicates that companies may lack investment opportunities and their development potential is affected. In addition, compared with non-current assets, current assets are more liquid and less risky, but they are less profitable. Excessive current assets are not conducive to improving profitability. Too little current liabilities indicate that the company's ability to use non-interest-bearing liabilities to expand its business scale is poor, because in addition to short-term borrowings, it is usually not necessary to pay interest. Therefore, enterprises should maintain an appropriate net working capital scale.

There is no uniform standard on how much net working capital is reasonable. The size of net working capital varies greatly across industries. Generally speaking, retailers have more net working capital because they have nothing but current assets to pay off equally stable current liabilities. Manufacturing industries generally have positive net working capital, but their amounts vary widely. Because the net working capital is related to the scale of operation, the net working capital of different companies in the same industry is also not comparable. Therefore, in practice, net working capital is rarely used directly as an indicator of a company's short-term solvency.

Limitations of net working capital

Since the net working capital is an absolute number, if the scale of the enterprises varies greatly, this indicator cannot be used to evaluate the short-term debt-paying capacity of the enterprises. At the same time, even if the net working capital of the two companies is exactly the same, their solvency is not necessarily the same. In addition, when the current liability is greater than the current assets, the net working capital is negative, indicating that it has no solvency at all; but from the current ratio, although its solvency is low, it can also be repaid if the company has a strong financing ability Its current liabilities. In order to eliminate the shortcomings of the absolute number indicator, the current ratio is often used to assist in judging the rationality of the amount of net working capital.