Every company has a set of assets and liabilities, of which some assets experience realisation earlier than others.
Similarly, the company also needs to pay some liabilities earlier than others.
A company at any time needs liquidity to pay those liabilities and continue smooth operation of the business.
Gross working capital shows the liquidity status of the company by telling us how much the company has invested in its current assets. But, what are current assets?
Let us understand the concept of Gross working Capital by first looking at the fundamentals of current assets.
Current assets define all the assets of a company that are foreseen to be sold, consumed, used, or depleted through standard business operations within one year.
Current assets are shown in the balance sheet under the head of current assets after the fixed asset head.
E.g., Cash and cash equivalents, Inventories, bills receivables, etc.
Gross working capital consists of all the current assets of the company. It refers to the concept in a quantitative nature.
Gross working capital means the total sum of such assets which can be converted easily into liquid form I.e., cash within one year.
It is an integral part of small companies as these companies depend most on their current assets, but it never shows the true liquidity of the company.
However, it does not add any significance to large and mid-size firms.
Overall, Gross Working Capital =Current Assets.
There are four main components of Gross Working Capital such as cash, inventories, accounts receivable, short-term investments, or marketable securities.
Cash is an operating asset which means such an asset is required in the daily routines of the business.
It includes the bank’s money from customers, undeposited cheques, and cash in hand.
Inventories means the stock of items that are important in the operation of the business entity.
It includes raw materials, work in progress, and finished goods.
Business owners hold such stock so that by selling them they earn profit from it.
Besides, it also helps in availing Cash Credit of the company.
Inventories do not constitute any cash inflow at present but they constitute a good portion of the gross working Capital.
In simple terms, it is known as debtors, which means an unpaid amount by the customers.
Customers may make purchases on credit for a credit period limit like a week, a month, and sometimes it may be a year.
Account receivable usually shows a debit balance in the trial balance sheet.
It is also an essential part of drawing power for availing Cash Credit.
As the name suggests, it refers to investments based on the short-term periods, which are highly liquid.
National saving certificates, Kisan Vikas Patra, and so on are some examples of the same.
The Gross Working Capital formula can be derived in various ways given the detailing of components included in current assets, two of which are as follows:
Gross Working Capital = Total Value of Current Assets.
Or,
Gross Working Capital= Cash and cash equivalents + inventories + Accounts Receivables + Short-term investments + Other Current Assets.
Suppose a company has a cash balance of Rs. 2000, Bank balance of Rs. 2000, Debtors of Rs. 1000, and inventories of Rs. 8000.
Then,
Gross working capital = Total of current assets
Current assets include sum total of cash and cash equivalents and bank and debtors and inventories.
Hence, for the above example the Gross working capital = Rs. 2000 + Rs. 2000 + Rs. 1000 + Rs. 8000
The total Gross working capital = Rs. 13,000.
Gross working capital has a plethora of crucial facets that make it vital for the investors and analysts as well as the company.
Listed below are some points stating the significance of Gross working capital and they are as follows:
Gross working capital shows the current assets of the company.
A company generally uses the current assets in daily operations, having a good current asset position may signify that company’s operations are working smoothly.
Gross working capital shows the total current assets of the company, the company uses the current assets to repay the current liabilities and the expenses.
Having a good working capital means the company could repay its liabilities and current expenses.
And having a low working capital means that the company could not repay its liabilities and current expenses.
The gross working capital consists of all the assets that will be converted into cash within 12 months.
This helps to determine how much potential cash flow the company has for the upcoming year.
Gross working capital adds significance to financial management as the financial manager could foresee the cash flow coming in the near future.
Managing the near future cash flow helps management to manage the company’s liquidity.
Net Working Capital = Current Assets (Gross working capital) – Current Liabilities.
If the result is positive then, the company’s current assets exceed the current liabilities, which means the company’s financial stability is good, and it can repay the liabilities within the stipulated period.
If the result is negative, that means business owners need to improve the financial strategy of the business so they can repay liabilities in the upcoming future.
Suppose a company has a cash balance of Rs. 2000, Bank balance of Rs. 2000, Debtors of Rs. 1000, and inventories of Rs. 8000, Trade payables of Rs. 1500, Bank overdraft of Rs. 2000 and other current liabilities of Rs. 3000.
Then,
Net working Capital = Total current assets – Total Current Liabilities.
Cash + bank + debtors + inventories – Trade payables – Bank overdraft – other current liabilities.
Gross working capital = Rs. 2000 + Rs. 2000 + Rs. 1000 + Rs. 8000 – Rs. 1500 – Rs. 2000 – Rs. 3000 = Rs. 6500.
Some transactions may affect the working Capital of the company and some might not.
The transactions that affect the working Capital may cause an increase or decrease in the working Capital, while the transactions not affecting the working capital result in no change in working capital.
There are some accounting activities that cause a change in working capital
Listed below are headings that help you understand the effect of such activities on the working capital.
The activities that result in an increase in the working capital are as follows:
Issuing debentures will cause an increase in the working Capital as cash inflow will occur and a long-term financial liability will be created.
The Debentures issued are not the current liabilities of the company while cash is a current liability.
Thus, issuing the debentures increases both gross working capital and net working Capital of the company.
Selling a non-current asset will cause an increase in the working Capital of the company as the cash inflow will occur, and a non-current asset will be disposed of.
Thus, selling a non-current asset will increase both gross working capital and net working Capital.
The activities that result in the decrease of the working capital are as follows:
The redemption of debentures means repaying the debentures.
It decreases the working Capital as a cash outflow will occur and Debentures get paid off. This transaction decreases the current assets and non-current liability.
Thus, redeeming the debentures decreases the gross working Capital and the net working capital.
Purchasing a non-current asset will cause a decrease in the working Capital of the company as the cash outflow will occur and a non-current asset is added.
Thus, purchasing a non-current asset will result in a decrease in both gross working capital and net working Capital.
For example, withdrawing cash from a bank account will affect the cash in hand and the bank balance but it will not affect the working Capital of the company.
In the same way, depositing cash to a bank account will affect the cash in hand and the bank balance but it will not affect the working Capital of the company.
For example, When you are purchasing a machine in exchange for shares of the company, there is an increase in the non-current asset and equity of the company.
Thus, it does not affect the working Capital of the company.
Before knowing how to manage the working Capital, we need to know why it is important for an entity to manage its working Capital. Gross working capital is the
Total of all current assets while the net working capital is the difference between total current assets and total current liabilities.
By managing the working Capital, entities try to manage the current assets and current liabilities and analyse the interrelationship that exists between them.
Thus, we can say that by analysing the working Capital, entities analyse the relationship between their current assets and the current liabilities.
The main aim to manage the working Capital is to deploy such amounts to current liabilities and current assets to maximise the short-term liquidity.
Now let us dig into the management of working capital:
The management of working capital involves the management of components of working capital, i.e., inventories, accounts receivables, cash, bank, etc., there are two core steps to manage the working Capital:
1) Forecasting the amount of working capital.
2) Determining the source of working capital.
The gross working capital differs from net working capital in various aspects.
In order to cover the difference in an easy manner, here is an all-encompassing chart explaining Gross working capital v/s net working capital.
Serial No. | Parameter | Gross Working Capital. | Net working Capital. |
1. | Meaning | Gross working capital is the summation of the current assets of the firm. | Net working capital is the difference between total current assets and total current liabilities of the firm. |
2. | Concept. | Gross working capital is a quantitative concept. | Net working capital is a qualitative concept. |
3. | Indicates what? | Gross working capital indicates the funds invested in the current assets of the firm. | Net working capital indicated the firm’s capacity to pay its current liabilities and operating expenses with no problem. |
4. | When does it change? | The value of Gross working capital changes with a change in the value of the current asset. | The value of net working capital changes only when a transaction has the first effect on current assets or liabilities and the second effect on non-current assets or non-current liabilities. |
5. | Components. | Components of Gross working capital are; Accounts Receivables, cash, cash equivalent, current investments, marketable securities, inventories, and other current assets. | Components of Net working capital are; Total current assets and the total current liabilities of the firm. |
6. | Formula. | Gross working capital = Cash and cash equivalent + Accounts receivables + marketable securities + inventories + short term investments + other current assets. | New working capital = Total current assets – total current liabilities. |
7. | Suitable to whom? | Gross working capital is normally suitable for companies. | New working capital is normally suitable for partnership firms and sole traders. |
8. | Use. | The Gross working capital concept is used to know the financial standing of the firm. | The Net working capital is used to know the liquidity of the firm. |
9. | Popularity in which field? | Gross working capital is popular in financial management. | Net working capital is popular in accounting systems. |
We have understood the basic concept of current assets, current liabilities, gross working Capital, and net working Capital.
Understanding these makes it easy for you to read the liquidity position of the firm. Knowledge of the liquidity position of a firm is an important factor to be looked at as it reflects the operating capacity of the firm.
A firm having huge non-current assets but low current assets will face a liquidity issue.
A balance between the current assets and current liabilities is also essential, the current ratio is the best way to determine the relationship between the current assets and current liabilities of the firm.
Current Ratio is a liquidity ratio that shows the position of current assets over the current liabilities of the firm.
The current ratio is computed by dividing the total current assets by the total current liabilities of the firm.
Thus, current ratio = Total current assets / Total current liabilities.
Liquidity indicates the firm’s ability or ease with which an asset or investment can be converted into hard cash without affecting the market price.
The most liquid asset is Cash.
In simple words, liquidity describes the degree to which the asset or investment can easily be traded in the market without changing its current intrinsic value.
For example, if a company needs Rs. 50 lacks to meet its current cash needs, but if it lacks cash in hand, then it has to convert the assets into cash to meet such needs.
The company then looks to its liquid assets for cash needs. The company can easily see its marketable securities to get a cash consideration to meet its current cash needs.
Marketable securities' ability to convert to cash in real-time is its liquidity.
A negative net working capital indicates that the firm will be unable to pay the current liabilities and current operating expenses.
Negative Net working capital appears when the firm’s current liabilities are greater than the firm’s current assets.
For example: suppose a company has total current assets of Rs. 500 lakhs and the total current liabilities of Rs. 800 lakhs.
Then, the company’s Net working Capital is - Rs. 300 (i.e., Negative 300 Lakhs). If the company has to pay the current liabilities, it would be short by Rs. 300 Lakhs.
Yes, the gross working Capital of the company includes the total current assets of the firm.
Current assets are the assets that can be easily converted into cash in 12 months. Thus, it is used to pay the current operating expenses and the current liabilities.
Current assets are fast-moving assets and thus can be used to gain knowledge of a firm’s operating cycles.
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