Net operating working capital (NOWC) is one measurement of a company’s financial health. It looks at how efficiently a company is managing its current assets and liabilities. Unlike plain net working capital, net operating working capital excludes cash and cash equivalents, since they are not tied up in operations. This makes net operating working capital more closely tied to current cash flows and a more accurate indicator of a company’s ability to sustain cash flow in the face of changes or obstacles.
Read on to learn how to calculate net operating working capital, why it’s important, how it differs from other measures of working capital, and see an example of a NOWC calculation.
What Is Net Operating Working Capital?
To understand what net operating working capital is, it’s helpful to know what working capital is.
Working capital is the money available to meet your current, short-term obligations. It’s calculated by subtracting current liabilities from current assets, as listed on the company’s balance sheet. Current assets are those that can be converted into cash within one year; current liabilities are obligations expected to be paid within one year.
Net operating working capital measures the difference between a firm’s current assets, such as inventory and accounts receivable, and its current liabilities, such as accounts payable and accrued expenses. Unlike net working capital, however, it excludes cash and cash equivalents, such as bank deposits and short-term investments, since they are not tied up in operations and can be converted into cash if needed.
NOWC also excludes debt (such as different types of small business loans) and interest-bearing securities, since these items represent a method of raising the necessary capital to fund ongoing operations.
Net Operating Working Capital Formula
Here’s a look at the net operating working formula:
Net Operating Working Capital (NOWC) = Operating Current Assets – Operating Current Liabilities
Operating current assets includes:
• Accounts receivable
• Accounts payable
• Inventory
Operating current liabilities includes:
• Accrued expenses
• Prepaid expenses
• Deferred revenue
Calculating Net Operating Working Capital
To calculate net operating working capital, you need to:
1. Determine your company’s current assets. These are assets that are expected to be converted into cash within one year. Examples include: accounts receivable, inventory, and prepaid expenses. You can find your company’s current assets listed on its balance sheet.
2. Determine your company’s current liabilities. These are debts that are expected to be paid within one year. Examples include: accounts payable, accrued expenses, and short-term loans. You can find a company’s current liabilities listed on its balance sheet.
3. Exclude cash and cash equivalents. Cash and cash equivalents are excluded from the NOWC formula because they are not tied up in a company’s day-to-day operations. These include: bank deposits and short-term investments.
4. Calculate net operating working capital. Now, you simply subtract your company’s current liabilities (excluding any short-term debt that has been used to finance current assets) from its current assets (excluding cash and cash equivalents).
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What Is Net Operating Working Capital Used For?
Calculating NOWC provides a measure of your company’s liquidity — or, in other words, its ability to meet its short-term financial obligations.
Having a high NOWC, for example, makes it easier to pay your bills as they come due. It also allows you to invest in growth opportunities when they come up and increase profits. If, on the other hand, a business has too little NOWC, it risks not having sufficient funds to pay off outstanding liabilities and may not be able to remain solvent. It will also lack funds to invest in future growth.
Once you have calculated NOWC, you can use it to analyze your firm’s financial health and compare it to industry benchmarks or its historical performance.
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Working Capital vs Net Operating Working Capital
| Working Capital | Net Operating Working Capital | |
|---|---|---|
| What it measures | Looks at all current assets and current liabilities | Only looks at current assets and liabilities related to daily operations |
| Focus | Broader | Narrower |
| Cash and short-term debt included? | Yes | No |
| Uses | Look at a firm’s overall profitability | Helps determine if a company can remain solvent |
Net operating working capital (NOWC) and net working capital (NWC) are both financial metrics that can be used to evaluate a company’s liquidity and overall financial health. NWC, however, includes all of a company’s current assets and liabilities, including cash and cash equivalents. It is calculated by subtracting a company’s current liabilities from its current assets.
NOWC, by contrast, is a narrower measure that excludes cash and cash equivalents from current assets, and short-term debt that has been used to finance current assets from current liabilities.
It is calculated by subtracting a company’s current liabilities (excluding any short-term debt used to finance current assets) from its current assets (excluding cash and cash equivalents).
As a result, NOWC tends to be a more precise measure of a company’s ability to fund its day-to-day operations. It hones in on the capital a company has tied up in its day-to-day operations, which is more relevant for short-term financial management.
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Net Operating Working Capital Example
Here is an example of how to calculate NOWC for fictional company ABC.
ABC’s operating current assets are:
Accounts Receivable = $5 million
Inventory = $30 million
Prepaid Expenses = $4 million
Total operating current assets = 39 million
ABC’s operating current liabilities are:
Accounts payable = $10 million
Accrued expenses = $7 million
Deferred revenue = $3 million
Total operating current liabilities = 20 million
We then plug theses numbers it to the NOWC formula:
Net Operating Working Capital (NOWC) = Operating Current Assets – Operating Current Liabilities
NOWC = 39 million – 20 million
NOWC = 19 million
Based on the operating working capital formula, ABC has a positive NOWC, which means it is capable of paying off all of its current operating liabilities with some assets left over. This indicates that things are going well — ABC could meet its obligations all at once if needed and still have funds left to cover their current operations.
Recommended: Balance Sheets Explained
The Takeaway
Net operating working capital measures a company’s short-term liquidity, meaning its ability to meet short-term financial obligations. If a company has a positive NOWC, it is able to cover all of its liabilities. If it doesn’t, some aspects of the business are likely not operating as well as they could.
Some ways to improve your company’s NOWC include: reducing inventory levels, improving collections from customers, negotiating better payment terms with your suppliers, and increasing operational efficiency.
You might also consider financing options, such as a working capital loan, which can provide short-term financing to cover operating expenses or factoring, where you sell its accounts receivable to a third-party for cash.
If you’re seeking financing for your business, SoFi can help. On SoFi’s marketplace, you can shop top providers today to access the capital you need. Find a personalized business financing option today in minutes.
FAQ
How are operating capital and operating working capital different?
Operating capital and operating working capital are the same thing: capital required to fund a company’s day-to-day operations. They can cover operational expenses, including inventory, accounts receivable, and accounts payable.
What does net operating working capital include?
To calculate net operating working capital (NOWC), you subtract operating current liabilities (accrued and prepaid expenses, plus deferred revenue) from operating current assets (accounts receivable, accounts payable, and inventory).
What is net operating working capital an indicator of?
Net operating working capital (NOWC) is an important indicator of a company’s short-term liquidity and its ability to meet day-to-day operational expenses. A positive NOWC indicates that a company has sufficient current assets to cover its short-term obligations, while a negative NOWC suggests potential liquidity issues.
Photo credit: iStock/miodrag ignjatovic
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