Cash, cash equivalents, inventory and accounts receivable are examples of working capital. Calculating net working capital is a way to measure the liquidity of an entity.
Net working capital is calculated by subtracting the current liabilities from the current assets on a company’s balance sheet. Current assets are cash and other assets that can be converted to cash in a year or less. Current liabilities are the financial obligations that a company is required to pay in the next year, and cash and cash equivalents are needed in order to fund the day to day operations of a business.
When there is a shortfall in working capital, a company is often forced to borrow funds through a bank line of credit to meet this need. The industry in which a company operates will contribute greatly to how it approaches working capital management. If a company converts raw materials to cash in a short period of time, having sufficient working capital on hand is less likely to be an issue. In contrast, when the cash conversion cycle is lengthy, maintaining sufficient operational funds can easily become a problem. One of the most common ways to improve working capital position is to collect receivables faster and delay the payment of accounts payable.