What Does Net Operating Working Capital (NOWC) Mean?
Net operating working capital is a financial metric that gauges the difference between a company’s non-interest bearing operating assets and its non-interest charging operating liabilities.
This liquidity ratio demonstrates how able a company is to pay off its current operational liabilities with its current operational assets. This ratio is important because it reveals the amount of leverage that the company carries along with its net operating assets. Ultimately, this ratio shows how well a company is able to use its current operating assets and how able it is to make changes to accommodate both new opportunities and unforeseen events. The formula for calculating net operating working capital is:
Cash + Accounts Receivable + Inventory – Accounts Payable + Accrued Expenses
This calculation is tied much more closely to current cash flows than the equation to determine plain net operating capital, because net working capital includes all of a company’s current assets and liabilities. Marketable securities and short-term debt are both excluded from this equation. This makes net operating working capital a much more accurate indicator of a company’s ability to sustain cash flow when changes or obstacles materialize. NOWC is therefore a component of TWC.
Divestopedia Explains Net Operating Working Capital (NOWC)
Net operating working capital is a direct measure of a company’s liquidity, operational efficiency and its overall financial health (at least in the short-term). Companies that have a large amount of NOWC versus their liabilities and accruals demonstrate that they have the potential to grow over time and also make investments if necessary. On the other hand, if its net operating working liabilities exceed its capital, then this could be a sign that the company is in at least some degree of financial trouble. If this is the case, then the working capital ratio will be less than one.
A positive working capital indicator is always greater than one, with one being the breakeven point. But net operating working capital that comes in above a certain amount may be considered by some analysts to be too high, as this could conceivably indicate that the company is carrying an excess amount of inventory or is not properly investing its excess cash. Ideally, a company should have a NOWC ratio of at least two-to-one so that there is some padding build into their cash flow.
It should also be noted that net operating working capital does not take either natural or human capital into account. This effectively allows companies to ignore any inefficiencies in their use of human or natural resources and assess their performance strictly according to what the numbers show. This allows investors to make apples-to-apples comparisons between one company’s cash flow and another’s without having to take the human aspect of operations into account. Net operating working capital is therefore critically important to know when assessing a company’s cash flow and balance sheet.
Frank’s Model Train Company has the assets listed below on its balance sheet:
Accounts Receivable: $60,000
Accounts Payable: $165,000
Accrued Expenses: $125,000
NOWC is then computed like this:
$150,000 + $60,000 + $350,000 = $560,000
$560,000 - $165,000 - $125,000 = $270,000
The remaining $270,000 of net assets show that the train company is capable of paying off all of its current operating liabilities with some assets left to spare. This is thus a clear indicator that the business is in good shape financially and can meet its obligations all at once if necessary, with something left to fund the company’s current operations.