The Common Definition of NWC and its Implications
NWC is commonly defined as the difference between capital assets and current liabilities. Efficient working capital management requires firms should operate with some amount of NWC, the exact amount varying from firm to firm depending, among other things, on the nature of industry. The theoretical justification for the of NWC to measure liquidity is based on the premise that the greater the margin by which current assets cover the short term obligations, the more is the ability to pay obligations when become due for payment. The NWC is necessary because the cash outflows and inflows does coincide. In other words, it is the non synchronous nature of cash flows that makes necessary. In general, the cash outflows resulting from payment of current liabilities are relative predictable. The cash inflows are, however, difficult to predict. The more predictable the inflows are, the less NWC will be required. The firm, electricity generation company, almost certain and predictable cash inflows can operate with lillie or no NWC. But where inflows are uncertain, it will be necessary to maintain current assets at a level adequate to current liabilities, that is, there must be NWC.
Alternative Definition of NWC
NWC can alternatively be defined as that part of the current which are financed in to long term funds. Since current liabilities represent sources of short funds, as long as current assets exceed the current liabilities, the excess must be financed long term funds. This alternative definition, as shown subsequently, is more useful for the a of the trade off between profitability and risk.