The Incremental Net Working Capital (NWC) measures the percent change in a company’s operating current assets and current liabilities relative to its change in revenue.
By analyzing historical data and projecting a company’s incremental net working capital (NWC), management and equity analysts can grasp a better understanding of the near-term capital investment need (i.e. equity injection).
The incremental net working capital (NWC) is the ratio between the change in a company’s net working capital (NWC) and the change in revenue in the coinciding period, expressed as a percentage.
The incremental net working capital (NWC) rate answers the question of, "How much of a company’s net revenue is tied up in its operating working capital to generate a dollar of revenue?"
Conceptually, an investment in net working capital (NWC) is a core value driver that contributes toward shareholder value creation.
Therefore, the efficient allocation of capital toward net working capital (NWC) increases the free cash flow (FCF) generated by a company – all else being equal.
The net working capital (NWC) metric – the difference between a company’s operating current assets and operating current liabilities – is a measure of a company’s near-term liquidity and capacity to meet its short-term obligations.
The process to calculate the incremental change in net working capital (NWC) is a six-step process:
The formula to calculate the incremental change in net working capital (NWC) divides the change in net working capital (NWC) by the change in revenue.
Where:
So, why does the change in net working capital (NWC) formula subtract the "ending" NWC balance from the "beginning" NWC balance?
In short, measuring the change in NWC by deducting the ending period balance from the beginning period balance tends to be more intuitive in terms of understanding the impact on cash (i.e. “inflow” or “outflow”).
If a company’s change in NWC increased year-over-year (YoY), a negative sign is placed in front to reflect that the company’s free cash flow (FCF) is reduced because more cash is tied up in operations.
Note: Consistency throughout the entire model is the priority when it comes to formatting and sign convention in financial modeling.
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Briefly, an increase in net working capital (NWC) is an outflow of cash, while a decrease in net working capital (NWC) is an inflow of cash.
Why? The incremental increase in net working capital (NWC) implies more cash is tied up in operations, reducing the free cash flow (FCF) of a particular company.
The general rules of thumb to interpret the change in operating current assets and current liabilities are as follows:
We’ll now move to a modeling exercise, which you can access by filling out the form below.
Suppose we’re tasked with calculating the incremental net working capital (NWC) of a company, given the following historical data.
| Selected Financial Data | Year 0 | Year 1 | Year 2 | Year 3 | Year 4 |
|---|---|---|---|---|---|
| Net Revenue | $200 million | $210 million | $220 million | $230 million | $240 million |
| Accounts Receivable (A/R) | $40 million | $46 million | $52 million | $58 million | $64 million |
| Inventory | $20 million | $22 million | $24 million | $26 million | $28 million |
| Current Operating Assets | $60 million | $68 million | $76 million | $84 million | $92 million |
| Accounts Payable (A/P) | $30 million | $35 million | $40 million | $45 million | $50 million |
| Accrued Expenses | $10 million | $11 million | $12 million | $13 million | $14 million |
| Current Operating Liabilities | $40 million | $46 million | $52 million | $58 million | $64 million |
Since the total operating current assets and operating current liabilities were provided, the next step is to calculate the net working capital (NWC) for each period.
The net working capital (NWC) is the difference between the total operating current assets and operating current liabilities.
Based on the computed NWC figures, the current operating liabilities of the company exceed the current operating assets.
In the next section, the change in net working capital (NWC) – i.e. the increase / (decrease) in net working capital (NWC) – will be determined.
The change in NWC is calculated by subtracting the current period NWC balance from the prior period NWC balance.
The net working capital (NWC) of the company is increasing by $2 million each period.
The parenthesis enclosed around each figure indicates a negative value – which to reiterate from our earlier section on sign convention – signifies an “outflow” of cash.
In the final part of our exercise, the incremental net working capital (NWC) will be calculated and expressed as a percentage.
The change in net revenue is the difference between the ending and beginning balance.
Given the step function used in our model, the formula to calculate the incremental NWC is constant.
Stated in gross terms, the incremental net working capital (NWC) is $10 million. However, the more practical method is to convert the figure into a percentage for forecasting (and comparability).
In conclusion, our hypothetical company’s incremental net working capital (NWC) rate implies that approximately 20% of its net revenue is tied up in its operations per dollar of incremental revenue.
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