# Change in Net Working Capital (NWC)

Guide to Understanding the Change in Net Working Capital (NWC)

• What does “Change in Net Working Capital” measure?
• Why does an increase in NWC represent a cash outflow (and vice versa)?
• Is it positive or negative if the change in NWC is increasing (or decreasing) over time?
• How is the change in NWC accounted for when calculating free cash flow?

## How to Calculate Net Working Capital (NWC)

The net working capital metric is a measure of liquidity that helps determine whether a company can pay off its current liabilities with its current assets on hand.

As a general rule, the more current assets a company has on its balance sheet in relation to its current liabilities, the lower its liquidity risk (and the better off it’ll be).

To review some basic accounting terminology:

• Current Liabilities: Obligations that a company is required to pay off (outflow) within the year – e.g. accounts payable, accrued expenses
• Current Assets: Resources that can be readily liquidated and converted into cash (inflow) or are expected to be used within the year – e.g. accounts receivable, inventory

While certain accounting textbooks will define the change in net working capital as current assets minus current liabilities, the more practical formula excludes cash and short-term investments like marketable securities and commercial paper, as well as any interest-bearing debt such as loans and bonds.

###### Net Working Capital (NWC) Formula
• Net Working Capital (NWC) = Operating Current Assets – Operating Current Liabilities

The reason is that cash and debt are both non-operational and do not directly generate revenue.

In fact, cash and cash equivalents are more related to investing activities because the company could benefit from interest income, while debt and debt-like instruments would fall into the financing activities.

###### Negative Net Working Capital (NWC)

In the absence of further contextual details, negative net working capital (NWC) is not necessarily a concerning sign about the financial health of a company.

For instance, if NWC is negative due to the efficient collection of receivables from customers that paid on credit, quick inventory turnover, or the delay of supplier/vendor payments, that could be a positive sign.

However, negative working capital could also be a sign of worsening liquidity caused by the mismanagement of cash (e.g. upcoming supplier payments, inability to collect credit purchases, slow inventory turnover). In such circumstances, the company is in a troubling situation related to its working capital.

## Change in Net Working Capital (NWC) Formula

Since we have defined net working capital, we can now explain the importance of understanding the changes in net working capital (NWC).

On the cash flow statement, the changes in NWC are essential because tracking these changes over time (e.g. year-over-year or quarter-over-quarter) helps assess the degree to which a company’s free cash flows are going to deviate from its accrual-based net income (“bottom line”).

Screenshot from Apple 3-Statement Model (Source: WSP Premium Package)

The formula for the change in net working capital (NWC) subtracts the current period NWC balance from the prior period NWC balance.

### Change in NWC Formula

• Change in Net Working Capital (NWC) = Prior Period NWC – Current Period NWC

As a sanity check, you should confirm that if the NWC is growing year-over-year, the change should be reflected as a negative (cash outflow), and the change would be positive (cash inflow) if the NWC is declining year-over-year.

## Increasing vs Decreasing Change in NWC

If a company’s change in NWC has increased year-over-year (YoY), this implies that either its operating assets have grown and/or its operating liabilities have declined from the preceding period.

An increase in the balance of an operating asset represents an outflow of cash – however, an increase in an operating liability represents an inflow of cash (and vice versa).

For instance, let’s say that a company’s accounts receivables (A/R) balance has increased YoY while its accounts payable (A/P) balance has increased as well under the same time span.

The net effect is that more customers have paid using credit as the form of payment, rather than cash, which reduces the liquidity (i.e. cash on hand) of the company.

As for payables, the increase was likely caused by delayed payments to suppliers. Even though the payments will someday be required to be issued, the cash is in the possession of the company for the time being, which increases its liquidity.

Therefore, a positive change in net working capital implies reduced cash flow for a company, whereas a negative change in net working capital means the opposite, an increase in cash flow.

###### Change in NWC and Free Cash Flow Impact

When calculating free cash flow, whether it be on an unlevered FCF or levered FCF basis, an increase in the change in NWC is subtracted from the cash flow amount.

But if the change in NWC is negative, the net effect from the two negative signs is that the amount is added to the cash flow amount.

As a result, an increase in NWC results in less free cash flows, while a decrease in NWC causes more free cash flows.

## Change in NWC Calculator – Excel Template

We’ll now move to a modeling exercise, which you can access by filling out the form below.

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## Change in Net Working Capital (NWC) Example Calculation

In our hypothetical scenario, we’re looking at a company with the following balance sheet data.

Balance Sheet (Year 0)

• Accounts Receivable (A/R): \$50mm
• Inventory: \$25mm
• Accounts Payable (A/P): \$40mm
• Accrued Expenses: \$20mm

Given those figures, we can calculate the net working capital (NWC) for Year 0 as \$15mm.

• Current Operating Assets = \$50mm A/R + \$25mm Inventory = \$75mm
• (–) Current Operating Liabilities = \$40mm A/P + \$20mm Accrued Expenses = \$60mm
• Net Working Capital (NWC) = \$75mm – \$60mm = \$15mm

As for the rest of the forecast, we’ll be using the following assumptions for each projected year:

Forecast Operating Assumptions

• Accounts Receivable (A/R): (+) \$10mm Growth YoY
• Inventory: (+) \$5mm Growth YoY
• Accounts Payable (A/P): (+) \$20mm Growth YoY
• Accrued Expenses: (+) \$10mm Growth YoY

Once the remaining years are populated with the stated numbers, we can calculate the change in NWC across the entire forecast.

Since the growth in operating liabilities is outpacing the growth in operating assets, we’d reasonably expect the change in NWC to be positive.

The change in NWC comes out to a positive \$15mm YoY, which means that the company is retaining more cash within its operations each year.

The illustrated rule here affirms that increases in operating current assets are cash outflows, while increases in operating current liabilities are cash inflows.

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Jon
March 4, 2022 7:27 am

Wanted to confirm Net Working Capital = Working Capital (Current Year) – Working Capital (Previous Year) ? In this article it states Change in Net Working Capital (NWC) = Prior Period NWC – Current Period NWC

At least that is what is outlined here https://www.wallstreetmojo.com/changes-in-net-working-capital/

Last edited 5 months ago by Jonathan Gutman
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