Gross working capital and net working capital -- meaning and how they are calculated
The total current assets of a company are referred to as the gross working capital. The assets that can be converted into cash within a year are known as a company's current assets. In addition to cash and bank balances, they also include inventories, accounts receivable, short-term investments, and marketable securities. Let’s look at gross working capital in greater detail.
A company's liquidity status cannot be ascertained from its gross working capital alone. To determine the net working capital, the company's current obligations must also be considered. The net working capital is the measure of a company's liquidity. It includes accounts payable, short-term loans, and other existing loans. Short-term financial commitments, such as those to the suppliers of raw materials and unpaid labour, are not considered. Thus, it is important to take the company's liquidity into account while calculating the net working capital of the company.
The gross working capital only provides a partial picture of a company's short-term financial health and capacity for effectively utilising short-term resources. Current liabilities make up the other half. Positive working capital indicates that the current assets exceed current obligations. The ratio of current assets to current liabilities (e.g., > 1.0) is the preferred way to represent positive working capital. A company has problems repaying its creditors in the short term if this ratio is less than 1.0. Liabilities exceeding assets result in negative working capital. It is a sign that the business is struggling.
Calculating Gross Working Capital
So, what is the formula to calculate gross working capital?
Gross working capital is equal to the sum of a company's current assets.
Current assets include inventory, trade receivables, short-term loans & advances, cash equivalents, and current investments. Trade payables, short-term loans, short-term provisions, and other current obligations are examples of current liabilities.
Net working capital = Total current assets - total current liabilities
A company is said to have positive working capital if its current assets exceed its current liabilities. It shows that the business has an adequate amount of funds to operate. If the company has negative working capital, it means that its current obligations exceed its current assets. This signals financial trouble for the business. As a result, it might not be able to pay back its creditors.
Business owners also compute the working capital ratio to determine the financial health of their company:
Working capital ratio = Current Assets / Current Liabilities
Importance of Gross Working Capital
The following points stress the significance of gross working capital:
● A thorough comparison of gross working capital to current liabilities provides a realistic assessment of the company's current obligations.
● An evaluation of a company's gross working capital provides information about the expected cash flow that owners will have at their disposal.
● It helps to calculate the working capital ratio. This, in turn, determines a firm's capacity to determine the financial standing and capability to repay liabilities properly.
● Gross working capital makes it possible for shareholders and investors to make wise investment decisions.
A firm's net working capital is more effective at predicting its liquidity. The weakness of gross working capital results from the fact that it is ineffective as a financial metric. Gross working capital does not provide accurate results if used to evaluate a company's financial performance or profitability. Thus, it does not accurately depict the company's liquidity and solvency situation. As a result, it has little significance. However, examining the company's net working capital is crucial. This is because it shows whether or not the company has the capacity to repay its short-term debts.
The sum of the company's current assets, including accounts receivables, cash, marketable securities, and inventories, is known as gross working capital. The value of the company's net working capital is obtained by subtracting the company's short-term financial commitments from the gross working capital.
Q. Do working capital investments increase the worth of the company's shareholders?
The difference between current assets and current liabilities is known as working capital. Since it doesn't require interest or sourcing from outside, this capital management entails fewer risks. When working capital is invested, shareholders' value can be increased. This can be done if liquid assets can be quickly turned into cash.
Q. Is fixed property a part of gross working capital?
No. Gross working capital does not include fixed assets. Due to their high liquidity, only current assets like cash, are counted in the gross working capital.
Q. What distinguishes net working capital from gross working capital?
The net working capital is the difference between the company's current assets and current liabilities. Gross working capital refers to the money that the company has invested in current assets. This implies that all current items, such as debtors, bills receivables, and stocks, will be included while calculating the gross working capital.
Q. What is the ideal working capital ratio?
The working capital ratio is equal to current assets divided by current liabilities. The ideal working capital ratio is 2:1. This means that for every rupee of current liabilities, the company should have two rupees of current assets. However, some industries can operate on a 1:1 ratio as well. Thus, it is always advisable to compare the working capital ratio of two businesses that are in the same industry.
Market capitalisation is a quick and simple way to calculate the company's value. The price of the shares is multiplied by the number of available shares, that is, issued and subscribed to, to arrive at the market capitalisation.
Return on equity (ROE) is a metric for evaluating a company's financial performance. It demonstrates the connection between earnings and investor returns.