First, let us see what is working capital?
Working capital is available capital that a company can use for day-to-day operations and represents the difference between current assets and current liabilities.
Working capital = Assets (cash, unpaid bills + inventories of raw materials + finished goods +, etc.) – liabilities (for example accounts payable)
Now, we need to see what is Non-cash working capital.
What is Non-cash working capital?
The Non-Cash Working Capital or NCWC represents the sum of inventory and receivables. The Non-Cash Working Capital (NCWC) is a financial asset calculated after considering the value of all the business’s current assets, excluding the cash component, and deducting the current liabilities.
Now to see the calculation:
Non-Cash working capital calculation
Non-cash working capital can be calculated in two ways: Calculate non-cash current assets and subtract current liabilities from the non-cash CA. for the current year or, the second way, add receivables, inventory, and subtract payables.
Non-cash working capital formula:
Non-cash Working Capital = Current Assets without cash – Current Liabilities
Non-cash Working Capital = Receivables + Inventory – Payables
Now let us discuss results:
The net change in non-cash working capital
If the net change in non-cash working capital is positive, additional capital is tied to working capital in the current year. If non-cash working capital is negative, then capital got released from working capital.
Usually, during the due diligence of a business that is being considered for sale, the historical NCWC of the company is calculated for each month for two or three years before the sale of the business. This will help the potential buyer understand the working capital that the business will require to ensure that the company will continue functioning, paying all the ongoing business expenses like the salaries.
The amount of NCWC required for running the business is one of the most disputed business aspects when the business owner is negotiating a business with any potential buyer. When a buyer purchases any business, the purchase price offered will usually cover the cost of the business’s current and fixed assets. This is because the industry will require these assets to function normally, to sell products or services as before, as the business did before the business sale was finalized. One of the assets whose value is considered in the business’s sale price is a reasonable amount for the NCWC.
Non-Cash Working Capital Example
A company with a sales revenue of $10 million has typically required approximately 15% of the sales value in NCWC. The NCWC amount for the business is $1.5 million. However, for other businesses in the same industry sector, the average NCWC is usually 10% of the sales revenue. Hence other businesses in the same sector had $10 million; the NCWC will be lower at two million dollars annually. This implies that the business being sold has historically required more working capital for its normal functioning than other similar companies in the same sector.
A potential buyer of the company may insist that the three million dollars which the company has historically required for running normally remain with the company, even if all other businesses in the same sector only require $ two million. Hence, a business owner needs to be aware of the business’s right working capital level based on industry standards. If the working capital required by the company is higher than the industry standards, it may be necessary to make some changes in the way the business is run so that it conforms to the industry norms.
A business owner needs to reduce the business’s working capital levels if they consider selling the business. This ensures that the business is not selling business with cash in working capital when the deal is being finalized with the buyer. By reducing the working capital reduced for running the company, the working capital’s money will be returned to the owner before the business sale is finalized. This ensures that the business owner gets the best deal from the company sale.
Non-Cash working capital cash flow:
Cash flow and non-Cash working capital will decrease if the company buys a fixed asset (for example, building).
Cash flow and non-Cash working capital will rise if the company sells a fixed asset (for example, building).
Let we summarize:
Change in working capital
Change in working capital can be seen in the cash flow statement such as:
- When a transaction increases current assets and current liabilities by the same amount, there is no change in working capital.
- Cash flow and working capital will decrease if the company buys a fixed asset (for example, a building).
- Cash flow and working capital will rise if the company sells a fixed asset (for example, a building).
- When the company purchases inventory with cash, there is no change in working capital, but inventory purchases will reduce cash flow.