Capital is the lifeblood of all enterprises. When properly managed, it keeps the lights on and the wheels turning. But what is working capital? Simply put, it is the financing poured in to meet daily operational costs. Without it, business would likely come to a halt. Working capital is calculated in two categories, net and gross working capital, each used to measure a different aspect of business finance. Both are critical parts of the financial structure, and good entrepreneurs work to maintain working capital in healthy reserves.
Many believe that working capital is a key indicator of a company’s financial health. This makes sense considering it not only funds daily operations but also clears the company’s debts. As an entrepreneur, you should know the distinction between the two categories, how they are calculated, and how to interpret these effectively. Here is what you need to know about net and gross working capital and their differences.
Gross working capital
This type of working capital is simply a measure of all the company’s currently held assets. Typically, only those assets that can be converted into cash in within a year can be classified under the umbrella of gross working capital. This means that it is a representation of the company’s short-term liquid resources. Some of the assets that qualify for this type of working capital include:
Cash
Debtors
Inventory
Securities
Prepaid expenses
Accounts receivable
Short-term investments
With an idea of these liquid assets, you can calculate the gross working capital using this simple formula:
Gross working capital = Trade receivables + Inventory + Marketable securities + Cash and cash equivalents + Prepaid expenses
Do note that using gross working capital to assess operational efficiency isn’t a valid approach. This is because this value is always positive and will thus provide an inflated interpretation. It does not account for any of the enterprise’s liabilities. However, knowing this value does offer insight when assessing the company’s financial health.
Net working capital
Unlike gross working capital, this accounting concept accounts for the company’s current liabilities in its calculation. As a result, it is a reliable measure of the company’s stability and operational efficiency. For this reason, it is also commonly referred to as working capital. Entrepreneurs must rely on net working capital to assess liquidity and business health. Calculating this value is easily done, but you must first be aware of the factors that constitute the current liabilities. Generally, these are:
Accounts payable
Short-term loans
Taxes
Customer deposits
Creditors
Long-term debts that will mature in a year
Once you have all the liabilities accounted for, you can calculate net working capital by using this formula:
Net working capital = current assets - current liabilities
Do note that net working capital can be negative or positive. Ideally, your business should maintain a positive ratio between the assets and liabilities, which is 2:1. This indicates that the assets can comfortably accommodate the liabilities, thus mitigating the risk of insolvency. Conversely, a negative ratio implies that the liabilities outweigh the assets and the company may not be able to keep up with its credit.
Difference between net and gross working capital
Take a look at the following table to see the clear differences in how they are calculated and how they should be interpreted.
Gross working capital | Net working capital |
It is a sum of all the company’s current assets. | It is calculated as the difference between the current assets and the current liabilities of the company. |
It provides insight into the short-term liquidity, but can misrepresent the actual financial standing of the company. | It is a comprehensive measure of the company’s financial position and operational efficiency. |
Its value is always positive. | It can be either negative or positive. |
With a better idea of the differences between net and gross working capital, you are in a better position to interpret your business’s financial standing. This also offers insight into the importance of maintaining a healthy net working capital. With adequate levels, you can weather downturns and also consider investing in growth. To complement your efforts, consider the Bajaj Finserv Working Capital Loan for business financing.
It is easy to avail, has a minimal requirement for documentation, and comes with a hassle-free application procedure. With it, you can access capital up to Rs.45 lakh to either bolster your cash flow or work towards expansion. The loan also has an expedited disbursal timeline as you can get approval within a few hours. To avail of these benefits and more, check your pre-approved offer today.
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