Working capital is a critical concept in the world of finance, but few people understand how it differs from non-cash working capital. Those that do understand have a huge upper-hand in recognizing the strengths and weaknesses in a business and in making sound investments.
In short, non-cash working capital is the difference between [current assets without cash] and [current liabilities]. In other words, it is calculated as [net working capital] minus [cash]. In parallel, it’s vital to note that the term “working capital” on the Cash Flow Statement inherently implies “non-cash working capital” because the goal of the statement itself is to arrive at a cash balance using non-cash accounts from the income statement and balance sheet.
Non-cash working capital helps us understand 5 key points about a business:
- Impact on Cash Flow
- How liquid current assets and obligations are
- Free cash flow
- Company valuations and DCF
- Causes of negative working capital
In this article we’ll cover these topics with theory and examples. You be able to impress your boss and coworkers by knowing what NCWC is and its importance in company evaluation.
Non-Cash Working Capital Formula
Non-cash working capital is calculated with the formula [current assets] – [cash] – [current liabilities]. It can also be written as [net working capital] – [cash].
If we expand these terms more, the formula would look something like:
[accounts receivable] + [inventory] + [bond holdings] + [stocks] + [notes receivable] + [treasury notes] + [other non-cash current assets] – [cash] – [accounts payable] – [current principle portion of long term debt] – [short term debt] – [accrued expenses] – [wages payable] – [taxes payable] – [short term deferred revenue] – [other current liabilities].
This is not a comprehensive expansion. There are other current asset and other current liability accounts not listed in this formula. The point is that we are subtracting, not adding, cash to current assets.
Non-Cash Working Capital Vs. Working Capital
If you’re not familiar with working capital, the concept is relatively easy to understand. Imagine you have a Watch company with assets and liabilities on its balance sheet. In its current assets (i.e those that are due within 1 year), there is watch inventory, accounts receivable, and cash in the bank. In its current liabilities, there are accounts payable, income taxes payable, and debts payable.
Working capital is a simple calculation that subtracts the sum of current liabilities from the sum of current assets to get a view on how well those upcoming assets cover the upcoming liabilities. For example, if a sum of $100 of debt is due by year end and there’s only $75 in current assets, the working capital is -$25. That means the company will need to find cash to pay its debts.
The tricky thing to understand is how cash fits into the picture. When cash makes up a large part of current assets, the dynamic is favorable to the company. Maybe only $50 of the total $100 liabilities is due this month, and the rest is due at year end. And maybe cash makes up $70 of the total $75 in current assets.
In this case, the company will be able to pay its obligations this month. That’s because the non-cash working capital is very low, coming in at $5 – $100 = –$95, with only $50 due within the month.
Impact on Cash Flow
Though the above examples may feel complex at first glance, just remember that cash is king. In situations where obligations are upcoming, the following is true: when you have a high net working capital, then you want a low non-cash working capital. This is because the lower the portion non-cash items make of the total, the more cash you have. Math rules!
In other words, the lower your NCWC capital, the better you are at covering upcoming obligations, given that normal net working capital > 0.
Non-Cash Working Capital Turnover Ratio
The idea of “turnover” is common in financial analysis. It tells the analyst how many times a given account depletes and repletes within a fiscal period (most often a year). For example, when we want to know inventory turnover, we divide sales for the year by total inventory on the balance sheet at year end. This gives us a number greater than one, such as 3.2.
The same thing applies to NCWC. It’s useful to know how many times items such as accounts receivable, inventory, and pre-paid liabilities as a group turnover. To do so, divide revenue by the sum of NCWC accounts. A common and healthy metric is between 7 and 10.
In most companies, a high NCWC turnover is good, because it means the company generates a lot of revenue with very little current accounts. That said, if a company can generate more absolute revenue by increasing its NCWC, this is best.
At the end of the day, companies look to maximize their profits, and revenue growth is a key metric for growing those profits.
Non-Cash Working Capital & Free Cash Flow
As mentioned in the first section, NCWC is by default what analysts and accountants refer to when they say “working capital” on a cash flow statement. Free cash flow operates the same way as a cash flow statement.
It takes all non-cash items away from the P&L to give investors a view on the company performance before any cash is paid to creditors or stakeholders (i.e banks and shareholders).
This means that net profit on the P&L must be netted for non-cash current assets and current liabilities such as accounts receivable and accounts payable. Any increases in accounts receivable is a reduction in cash, and any increases in accounts payable is a increase in cash.
The beauty of using NCWC is that cash is already removed from the equation. You simply need to subtract increases in current assets and add back increases in accounts payable.
Non-Cash Working Capital & DCF
In the same vein as Free Cash Flow, DCF is related to valuations. It uses the present value of future cash flows as a base for how much a company is worth. The future cash flows that enter into the equation for DCF are the free cash flow figures as discussed above.
In other words, non-cash working capital is priority over normal net working capital when it comes to evaluating a company based on DCF.
Some people argue that free cash flow is not a good metric, and that only taxes should be added back to get a cash number. The argument goes that when companies net current assets and current liabilities, they’re not reflecting the true nature of operations and how cash stays tied up in the company.
Negative Non-Cash Working Capital
A question that often comes up in discussions about NCWC is if it can be negative, and what the impact on the company is when it’s less than 0. The answer is yes, non-cash working capital can absolutely be negative.
As discussed above, as long as normal working capital is positive, then negative NCWC does not signify a negative impact on the business.
On the contrary, it can mean that the company has leftover cash to pay for short- and long-term obligations, reinvest in the company, and of course, pay out to investors.
So what causes a negative working capital? In a sentence, working capital becomes negative when upcoming obligations are greater than upcoming or current cash. This can happen when companies buy too many materials on credit, or when they loose control of debt payments.
Is cash included in working capital?
This article can help us understand that yes, cash is included in working capital when we refer to it on the balance sheet. However, cash is not included in working capital on the statement of cash flows (SCF), since the purpose of the SCF is to determine cash movements indirectly.
In practice, you may hear people refer to working capital in both the sense that is includes and excludes cash. This is a challenge for analysts and investors. The hallmark of an experienced financial mind is the ability to deduce, based on context, when others are talking about working capital, or really mean to say non-cash working capital.
