Capital is the lifeline of every business. Any organisation, large or small, requires capital to finance each step of its operations, be it for the long-run or short-run. Working capital is what an enterprise pours into its day-to-day operations. Naturally, working capital acts as a reliable indicator of a company’s financial health.
Working capital can be classified into two categories: gross working capital and net working capital. The difference between gross working capital and net working capital is, therefore, essential to understanding its usage as a financial health indicator.
What is Gross Working Capital?
Gross working capital is the sum of a company’s current assets. These assets represent a company’s short-term financial resources, which it can convert into cash within a year or less. It includes inventory, debtors, cash and cash equivalents, marketable securities, and prepaid expenses.
Thus, Gross Working Capital = Trade receivables (debtors) + Inventory + Marketable securities + Cash and cash equivalent + Prepaid expenses
However, when it comes to the assessment of an organisation’s financial health, gross working capital only presents half a picture.
That’s because it does not take into account the current liabilities that a company is supposed to mitigate using the short-term financial resources at its disposal. Naturally, gross working capital is always positive.
Therefore, using gross working capital as a basis for determining a company’s operational efficiency depicts a skewed and inflated picture.
What is Net Working Capital?
The only objective difference between gross and net working capital is that the latter takes into account current liabilities. Resultantly, net working capital can be positive or negative.
Such current liabilities include trade payables or creditors, short-term loans, dividends payable, long-term debts maturing within a year, etc.
One needs to deduct these items from current assets or gross working capital to reach net working capital.
Therefore, Net Working Capital = Current Assets – Current Liabilities
In books, however, it is simply written as working capital. Nevertheless, between gross working capital and net working capital, the latter paints a clearer understanding of a company’s short-term financial health, and, in turn, its operational efficiency.
That’s because investors can then grasp how well a company is managing its liabilities in the short-run with its financial resources.
Let’s take an example to comprehend better why the net working capital is a more definite indicator of a company’s financial health.
Suppose, a company’s books show trade receivables to be Rs.3 lakh, inventory as Rs.5 lakh, cash and cash equivalent as Rs.2 lakh.
Adding up the numbers, the gross working capital stands at Rs.10 lakh. In the previous year, it was Rs.8 lakh.
An investor compares these figures and deduces such an organisation to be in a good state. However, in the previous year, its current liabilities showed a total of Rs.5 lakh; in this year, it’s reckoned at Rs.9 lakh.
Therefore, while the company’s gross working capital has grown (Rs.2 lakh), its net working capital has reduced (Rs.2 lakh), as compared to the past year. Hence, understanding the difference between net and gross working capital is critical for an investor in assessing an organisation’s operational efficiency.
However, it does not end merely at that. Investors also need the backing of crucial metrics related to working capital to that end.
Working Capital Metrics
As mentioned earlier, net working capital, or only, working capital can be negative or positive.
A positive figure shows that current assets are more than sufficient to meet the current liabilities.
Conversely, negative value denotes that total current liabilities have surpassed current assets in a specific year. As an investor, the former is always a desirable situation than the latter.
- Current ratio
A key metric underlining the relationship between current assets and current liabilities is the working capital ratio or current ratio.
Current ratio = Gross Working Capital or Current Assets / Current Liabilities
When this ratio is 1 or above, it means that such an organisation has enough funds to meet its operating expenses and short-term debts. Ideally, this ratio should be 2:1.
- Acid-test ratio
It is the ratio between a company’s most liquid assets and its current liabilities. Also known as the quick ratio, it denotes the short-term liquidity position of an organisation.
Quick ratio = (Current Assets – Inventory – Prepaid Expenses) / Current Liabilities
Like, working capital ratio, this should also ideally be positive.
Therefore, alongside the difference between gross working capital and net working capital, individuals should take into consideration these crucial metrics when assessing a company’s short-term financial position.
Understanding Working Capital
Just as a negative working capital figure is not desirable, it can also indicate managerial inefficiency if it is too high.
When the net working capital is unreasonably high, it indicates that such an organisation can put the excess money to better use, rather than keeping it idle.
Moreover, investors might also benefit if they assess gross working capital against individual elements of current liabilities. Such points of difference between gross working capital and net working capital can provide valuable insights, offering for a more concrete analytical foundation.
Difference between Net and Gross Working Capital
Here’s a tabular illustration of the few points of distinction between net and gross working capital:
|Parameter||Gross Working Capital||Net Working Capital|
|Calculation||It is the sum total of a company’s current assets.||It is the difference between an organisation’s current assets and current liabilities.|
|Value||It is always positive.||It can be both negative and positive.|
|Efficiency in gauging an organisation’s financial standing||Gross working capital may misrepresent the short-term financial position of an organisation.||Net working capital depicts a more comprehensive picture of a company’s operational efficiency.|
Investors must keep in mind these crucial points of difference between gross working capital and net working capital for a sound analytical approach of an organisation’s financial position.