Why NWC Matters in Project Cash Flow Analysis
Imagine you are starting a new lemonade stand. To get it going, you don’t just need to buy the stand itself, which might be considered a long-term investment. You also need lemons, sugar, water, cups, and maybe some ice. These are the everyday items necessary to operate your lemonade stand – the things you need to have on hand right now to make sales. In business terms, these short-term operational needs are very much like what we call net working capital.
Net working capital, or NWC, is essentially the lifeblood of day-to-day business operations. It’s the difference between a company’s current assets and its current liabilities. Think of current assets as resources that can be readily converted into cash within a year. This includes things like inventory – the lemons and sugar for your lemonade – accounts receivable, which is money owed to you by customers who bought lemonade on credit, and of course, actual cash on hand. Current liabilities are obligations due within a year, such as accounts payable, which is money you owe to your supplier for the lemons and sugar, and short-term loans.
When we evaluate a new project, whether it’s launching a new product line, expanding into a new market, or even building a new factory, we need to consider not just the big, upfront investments like equipment or buildings, but also the investments required in net working capital. Why is this so important? Because most projects, much like our lemonade stand, require an increase in short-term operational resources.
Let’s say your lemonade stand becomes incredibly popular, and you decide to expand. You need to make more lemonade, which means you need to buy more lemons and sugar – increasing your inventory. If you start allowing customers to pay later, you create accounts receivable. This increase in inventory and accounts receivable ties up cash. You’ve invested cash in these operational necessities. Similarly, if you get a bit of credit from your lemon supplier, allowing you to pay them later, this increases your accounts payable and somewhat offsets the cash tied up in other areas of NWC.
These changes in net working capital directly impact a project’s cash flow. Initially, at the start of a project, you often need to invest in NWC. This means you’re using cash to build up inventory, extend credit to customers, and manage your short-term obligations. This initial investment in NWC is a cash outflow, just like buying equipment. It’s a necessary cost to get the project running smoothly.
Throughout the project’s life, NWC levels might fluctuate. As sales grow, you might need to increase inventory further, requiring more cash. If sales slow down, you might be able to reduce inventory, freeing up cash. These changes, whether increases or decreases in NWC, represent cash flows that need to be accounted for in project analysis.
Crucially, at the end of a project’s life, ideally, you recover the investment in net working capital. For example, you sell off any remaining inventory, and customers eventually pay off their outstanding balances in accounts receivable. This recovery of NWC at the project’s end is a cash inflow.
If we ignore investments in net working capital when evaluating a project, we get an incomplete and potentially misleading picture of its true profitability. We might overestimate the project’s cash inflows in the early years and underestimate the cash outflows needed to support its day-to-day operations. Failing to account for NWC can make a project appear more attractive on paper than it is in reality. It’s like forgetting to factor in the cost of lemons and sugar when calculating the profit from your lemonade stand. You might think you’re making more money than you actually are if you only consider the price of the stand itself.
Therefore, considering investments in net working capital is absolutely essential for a comprehensive and accurate assessment of project cash flows. It provides a more realistic view of the cash required to support the project over its entire lifecycle, from initiation to completion, and ensures sound financial decision-making. It’s about understanding the total financial picture, both the big investments and the vital day-to-day operational needs that keep the project running.