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Tata Capital > Blog > Loan for Business > Net Working Capital: Meaning and Importance of Net Working Capital Ratio

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Net Working Capital: Meaning and Importance of Net Working Capital Ratio

Net Working Capital: Meaning and Importance of Net Working Capital Ratio

While you don’t need a degree to start and run a business, getting versed with certain terminologies can certainly help you make the right decisions. Financing is an important aspect of any business. One of the most used terms you will encounter while running your business is net working capital. Working capital lays down the foundation for the cash flow and working capital cycle for any business. Therefore, it is important to understand what is net working capital and how it impacts your business.

Net Working Capital Definition

In simple terms, net working capital means the difference between current assets and current liabilities. It helps to measure the short-term liquidity of a business. This shows whether the business has sufficient cashflows to meet the short-term obligations and continue funding the operations or not. Thus, the net working capital can be calculated using the following net working capital formula:

Net Working Capital = Current Assets – Current Liabilities

Therefore, to accurately understand the net working capital definition, you need to understand the meaning of current assets and current liabilities.

1) Current Assets

Current assets are assets that are highly liquid and are easily convertible into cash or cash equivalents. Generally, the assets that will be converted into cash or cash equivalents within 1 year are classified as current assets. Here are some of the assets that are normally classified as current assets:

Cash and Cash Equivalents: These are by default current assets. Cash equivalents normally include bank cheques, short-term fixed deposits etc.

Accounts Receivable: Accounts receivable are also classified as current assets as these are basically debtors from whom the payment is expected to be realised within the next 30-120 days.

Inventory: Inventory for any business is normally classified as current assets as these are expected to be sold shortly.

Short-Term Securities/Marketable Securities: Short-term securities like treasury bills, short-term deposits etc. having a maturity period within 1 year are classified as current assets.

2) Current Liabilities

Current liabilities are the liabilities that are already due or are expected to be payable within 1 year. This normally includes all the short-term debt. Further, long-term debts that will be repayable within 1 year are normally reclassified as current liabilities. Here are some of the liabilities that are normally classified as current liabilities:

Accounts Payable: These constitute the creditors i.e., the suppliers, vendors or manufacturers of the business. As these are mostly payable within a year, they are classified as current liabilities.

Short-Term Loans: These are the loans that are repayable within 1 year and hence, are classified as short-term loans.

Long-Term Loans Payable Within a Year: In most cases, a certain portion of long-term loans are repayable within a year in the form of EMIs. These constitute both principal and interest payments. The portion of long-term loans that are payable within a year are classified as current liabilities.  

Accrued Expenses: The accrued expenses constitute outstanding expenses apart from the creditors. Its examples include salaries payable, utility bills payable etc. As these are also payable within a period of 1 year, therefore these are also classified as accrued expenses.  

Why is Net Working Capital Important?

Understanding and periodically monitoring the net working capital ratio is important as it shows the liquidity of the businesses. A positive net working capital shows that the company has enough liquidity to meet short-term obligations. Consistently portraying a positive net working capital further indicates sound cash flow and good financial standing.

Conversely, negative net working capital indicates that the company’s resources are blocked in illiquid avenues that could pose a threat to meeting short-term obligations. In the long run, it could create liquidity crises. Failure to meet short-term obligations like creditor payments can further harm the goodwill of the company. In this case, the company needs to be sure to have enough liquidity to never miss out on short-term payments.

How You Can Improve Net Working Capital?

Here are some of the peculiar ways to improve the net working capital ratio for your business:

Longer Credit Cycles for Creditors: You should try to negotiate a longer credit period with your creditors. This will buy you more time to meet their payments.

Avail of Working Capital Loans: You can avail of working capital loans as they bridge the working capital gap for your business. This will always ensure that you do not miss out on your short-term obligations.

Shorter Credit Cycles for Debtors: If you can recover your payments faster from your debtors, then you can seamlessly meet your creditor’s payments.

Faster Inventory Turnover: A faster inventory turnover will ensure that your stock gets cleared and converted to cash faster.

In a Nutshell

Net working capital ratio is an important component of any business and regularly monitoring it is important to keep your business operations smooth and seamless. In case you are facing a working capital crunch or have negative net working capital, you should consider going for a working capital loan. TATA Capital’s business loan is an unsecured credit facility up to Rs. 75 lakhs that ensures you never miss out on your short-term obligations. You can select a tenure between 12 months to 60 months depending upon your financing and business needs. The business loan can be availed of either in the form of a term loan or an overdraft facility. Further, being an unsecured financing facility, you don’t need to provide any collateral facility.

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