Thursday, January 28, 2010

Net Working Capital - a reflection of the design and execution of a business model

An organization can improve its financial performance without increasing revenues or lowering costs. With two organizations generating the same revenues and costs, the one that needs the least financial investments will generate the highest return on investments, and have the highest freedom of action. Many interesting and innovative business models implemented by companies such as Dell, Southwest Airlines, Toyota and Zara, have at its core an effective Net Working Capital model. This post is an introductory to the concept and will be followed by a post exploring it further, with examples from different industries.

What is Net Working Capital?
Net Working Capital (NWC) is defined as current assets minus current liabilities and is a financial metric which represents operating liquidity available to a business. It indicates the firm's ability to convert its resources into cash and by quickly turning resources into cash, have the ability to put the cash to use again, ideally to reinvest and make more sales.

Current Assets comprises of cash and cash equivalents, inventory, and accounts receivable. To take a manufacturing company as an example: it needs cash to buy raw material or components (inventory), use the material in production (work-in-process inventory) to produce finished-goods (finished-goods inventory), to sell to customers who might get some days to pay (creating accounts receivables).

Current Liabilities includes accounts payable for goods, services or supplies that were purchased for use in the operation of the business. In the case with the manufacturing company above perhaps it didn't have to pay cash for the raw material or components, but had some creditor days (creating accounts payable).

Net Working Capital can thus be positive or negative depending on when raw material is paid to suppliers, how long the goods are in inventory and when goods are paid by customers.

Positive NWC:

Negative NWC:

Let's assume that the manufacturing company buys raw material and convert it to products which it sells on average after a total of 20 days in inventory, plus providing customers with 20 days to pay, creating total current assets (other than cash) of 40 days.

Scenario 1 - Positive NWC: The manufacturing company needs to pay its suppliers in an average of 30 days. The cash it takes to finance the business is 10 days multiplied by average sales per day.

Scenario 2: Negative NWC: The manufacturing company needs to pay its suppliers in an average of 60 days. The company has 20 days multiplied with the average sales per day in cash surplus, cash that can be used for other things.

Funding growth
If the company in Scenario 1 is growing rapidly, increasing amounts of cash will be needed to pay its suppliers and eventually to hire more people, and the cash from sales will never be able to catch up thus other sources of cash is needed. Failing to find additional sources of cash, profitable companies sometimes go bankrupt. If the company in Scenario 2 is growing rapidly, increasing amounts of cash will be available to fund the growth and other initiatives.

Capital always comes at a price
Different business models require different amounts of working capital depending on things such as the need for different inventory, when customers pay and when suppliers are being paid. Companies with business models that can use cash from customers require less investment and can thus generate higher return on those investments. Companies with business models that need lots of working capital will have to raise it from somewhere and capital always comes at a price.

How much NWC is needed?
All components of a business model have an effect on NWC and every organization needs enough cash and inventory to do its job. Reducing inventory too much and the production might be interrupted, push the suppliers too hard and they might run out of cash and perhaps go bankrupt, push the customers too much and they will go to someone else, too much leverage using other organization's assets and you might lose control. Finding the right balance is a challenge and using the business model concept to identify tied up cash can be a very useful exercise.

Using the business model concept
In the next post I will exemplify how the business model concept and business model innovation can have a huge direct effect on Net Working Capital but also have indirect effects such as improved efficiency, quality or customer satisfaction. It will be a "How to" post with questions to ask to find where money is tied up, and money tied up in working capital is money not available to grow the company.

Further reading:


  1. Great post and helpful diagrams, Anders! I'll add that Costco has also done well with negative NWC. I'm looking forward to your follow-on post (in particular about Zara or Southwest's negative NWC, if you happen to write about those.)

  2. great, nice clear, concise post! thank you!

  3. Great post! You really give a clean conception of what working capital is and how it works. Thanks for sharing this great content. It's hard to find good content like this!

  4. Thank you all!

    @Andrea There is a great case study on Costco in the book Getting to Plan B. Book review/summary:

  5. Thanks for sharing this great content! The diagrams were very helpful, good work.

  6. You really give a clean conception of what working capital is and how it works. Thanks for sharing this great content. It's hard to find good content like this!

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  7. You’re right but in some point you need to increase working capital for a better service and outwit competition. We are now in a very demanding era where technology is king. To level with competitors we need to invest for technological innovation. If financing is the problem we can always apply for loans, loans may be mark as liability but it can produce many assets in return. And as a result it increases revenues and can pay the merchant in a short span of time.

  8. Thank you so much for this post. Through your words and also the diagrams you really explain well and give us a great understanding of Working Capital. Keep the posts coming. It is difficult to find information like this.
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