Net Working Capital (NWC)
NWC is the money tied up in running the business day-to-day (inventory, receivables, minus payables). Increases in NWC consume cash; decreases free up cash.
Definition
Net working capital (NWC) measures the difference between a company's operating current assets and operating current liabilities. It represents the short-term capital needed to fund day-to-day operations. Changes in NWC are a critical component of free cash flow calculations.
Formula
NWC = Current Assets (excl. cash) - Current Liabilities (excl. debt)
Current Assets (excl. cash)
Accounts receivable, inventory, prepaid expenses — exclude cash and short-term investments
Current Liabilities (excl. debt)
Accounts payable, accrued expenses, deferred revenue — exclude short-term debt and current portion of long-term debt
Working Capital Formula
Current Assets minus Current Liabilities
Positive working capital means the company can cover its short-term obligations and still have a cash cushion for operations.
Cash Conversion Cycle
How long it takes to turn inventory into cash
DIO (30) + DSO (45) - DPO (35) = 40 days. This means the company needs to fund 40 days of operations before cash comes back in. Lower is better — it means less cash tied up in the cycle.
Why NWC Matters for Cash Flow
An increase in NWC means the company is tying up more cash in operations (e.g., building inventory or extending more credit to customers). This is a cash outflow that reduces free cash flow. A decrease in NWC releases cash (e.g., collecting receivables faster or stretching payables). In DCF models, the change in NWC is subtracted from NOPAT to calculate unlevered free cash flow.
NWC in M&A and LBOs
In M&A, a 'NWC target' or 'NWC peg' is set in the purchase agreement — the seller must deliver a minimum level of working capital at close. If actual NWC at close is below the peg, the purchase price is adjusted downward (and vice versa). In LBO models, NWC changes are projected as a percentage of revenue to estimate cash conversion each year.
Analyzing NWC Trends
Key metrics include days sales outstanding (DSO), days inventory outstanding (DIO), and days payable outstanding (DPO). The cash conversion cycle = DSO + DIO - DPO. A growing business typically requires increasing NWC, which is a drag on FCF. Companies that can grow while maintaining or reducing NWC (like negative-NWC businesses such as Amazon) generate superior cash flow.
Worked Example — With Real Numbers
A company has accounts receivable of $80M, inventory of $60M, prepaid expenses of $10M, accounts payable of $50M, and accrued expenses of $30M. NWC = ($80M + $60M + $10M) - ($50M + $30M) = $70M. If NWC was $60M last year, the $10M increase is a cash outflow that reduces FCF by $10M.
Key Takeaways
Exclude cash and debt from the NWC calculation — focus on operating items only
Increases in NWC consume cash and reduce free cash flow; decreases release cash
NWC is projected as a % of revenue in DCF models to estimate future cash needs
In M&A, NWC pegs protect the buyer from the seller stripping working capital before close
Negative working capital businesses (collect before paying) generate superior cash flow
Common Mistakes in Interviews
Including cash or debt in the NWC calculation — these are financing items, not operating
Forgetting to subtract the change in NWC (not the level) in FCF calculations
Not understanding that a growing business typically needs more NWC, which is a cash drag
How Interviewers Test This
You will be asked 'what happens to cash flow when working capital increases?' — the answer is cash flow decreases. Walk through a concrete example: if AR increases by $10M, you've delivered product but haven't collected cash yet, so it's a $10M cash outflow.
Related Concepts
Directly referenced in this topic
Free Cash Flow
Free Cash Flow (FCF) is the cash a company generates from operations after deduc...
Accounts Receivable
Accounts receivable (AR) is the amount of money owed to a company by customers w...
Accounts Payable
Accounts payable (AP) is the amount a company owes to its suppliers and vendors ...
Balance Sheet
The balance sheet is a financial statement that reports a company's assets, liab...
More Accounting Concepts
55 more concepts in this category
Related Articles
Topic Guides
Firms That Test This
Related Articles
Practice Net Working Capital (NWC) questions
400+ interview questions with AI feedback. Free to start.
Start PracticingMaster Net Working Capital (NWC) and 100+ More Concepts
Get the full IB Flash experience and walk into your interview with confidence.
AI Interview Coach
Real-time feedback on your answers
1,000+ Practice Questions
Across IB, PE, HF, VC & more
Financial Modeling Tests
Excel-based skill assessments
Or explore our free tools to get started