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Using Net Working Capital in Financial Planning with Business Owners | RISR Encyclopedia for Financial Advisors working with Business Owners Using Net Working Capital in Financial Planning with Business Owners
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Net working capital

✨ In summary

Net Working Capital (NWC) is a measure of a company’s short-term financial health and operational efficiency. A positive NWC means the business has more short-term assets than liabilities and can meet its upcoming obligations. A negative NWC may signal liquidity issues within the business.

 

Since financial planning with business owners focuses primarily on the Equity Value of the business, NWC plays a key role in estimating business valuation and the proceed potential of a business owner. Positive NWC directly increases the Equity Value of a business, while negative NWC decreases the Equity Value of a business.

Estimating net working capital

NWC is estimated as the different between current assets and current liabilities. 

  • Current Assets: Cash, accounts receivable, and other assets expected to be converted to cash within 12 months.

  • Current Liabilities: Accounts payable, credit cards & short-term debt, and other obligations due within 12 months.

Net Working Capital = Current Assets – Current Liabilities

Impacts of net working capital on valuation

When working with business owners as a financial advisor, it’s important to focus on the Equity Value within the business.

 

In the event of a sale, debt liabilities would first need to be satisfied with any excesses in liquid assets. The remaining value after satisfying these obligations represents Equity Value, the value the shareholders are owed. 

 

Equity Value = Enterprise Value + Net Working Capital - Interest-bearing Debt

 

When estimating business valuation, NWC represents the amount of liquid assets a business has to satisfy short-term and long-term obligations. 

  • Liquid assets are represented as Current Assets in the NWC calculation
  • Short-term obligations are represented as Current Liabilities in the NWC calculation
  • Long-term obligations consist of any interest-bearing debt that is not due in the next 12 months

Net working capital in financial planning

In addition to its impacts to estimating business valuation and the liquidity potential of the business within a client's financial plan, NWC may be used as an indicator of capital needs fro the business or opportunities to diversify earnings. 

 

  • Businesses with negative NWC may require operational changes or new capital in the form of loans or investments.
  • Businesses with positive NWC may have an excess of liquid assets.

 

In cases of positive NWC, discuss whether excess liquid should be reinvested in the business for growth or diversified out of the business as compensation to the owner top inform cash flow planning with clients. 

 

Keep in mind that a healthy level of NWC is needed continuously to meet day-to-day obligations and run the business. The amount of NWC that is considered healthy varies by industry, seasonality, and business model, so work with your client to get an understanding of what they need and what may available for reinvestment. 

 

 

Frequently asked questions

Is higher NWC always better?
Not necessarily. Excessive NWC may mean the company is holding too much inventory or idle cash instead of reinvesting in growth or returning value to owners.
What is a healthy level of NWC?
It varies by industry, seasonality, and business model. For example, service-based companies may operate with low NWC, while manufacturers often need more to support production cycles. Search for industry-specific benchmarks to get an idea of what ranges of NWC are appropriate for your client. 
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