Gross working capital is the total of a company’s current assets, presenting a snapshot of its operational liquidity. Understanding this fundamental aspect is paramount for any business aiming for efficient financial management.
What is gross working capital?
Gross working capital refers to the entirety of a company’s current assets. It encompasses cash, inventory, accounts receivable, and short-term investments. Essentially, it’s the amount needed to fund day-to-day operations.
One can undertake a thorough analysis of gross working capital to get an idea about the current liabilities of a business. It provides a clear idea to business owners about a business’s cash flow and helps them understand the financial health of a company.
Formula of gross working capital
The formula for calculating gross working capital is as follows:
Gross Working Capital = Total Value of Current Assets
Gross Working Capital = (Receivables + Cash and Marketable Securities + Inventory + Short Term Investments + Any Other Current Asset)
Calculation of gross working capital
You have to add current investments, trade receivables, cash, short-term assets, inventory, commercial papers, and other current assets to arrive at a company’s gross working capital.
Let’s understand this better with an example.
Suppose the current assets of a company are as follows:
- Cash and equivalent = Rs. 40,000
- Marketable securities = Rs. 45,000
- Accounts receivables = Rs. 20,000
- Inventories = Rs. 7,500
- Short-term investments = Rs. 65,000
- Other current assets = Rs. 10,000
So, Gross Working Capital = Rs. (40,000 + 45,000 + 20,000 + 7,500 + 65,000 + 10,000) = Rs. 1,87,500
Classification of gross working capital
The classification of gross working capital includes the following components:
- Accounts receivables: Accounts receivable is the term used to denote the amounts that a company is supposed to receive from its customers for goods and services purchased on credit.
- Cash and cash equivalents: This category includes loose cash, the amount in a company’s bank accounts, and short-term investments. All of these assets can be quickly converted into cash.
- Inventory: This comprises the goods a company holds for production, resale, or raw materials used in manufacturing.
- Short-term investments: When a company invests in financial instruments that have a maturity period of a year, such as money-market funds and treasury bills, is known as short-term investments.
- Prepaid expenses: These represent payments made in advance for goods and services that will be used in the near future. Examples include prepaid insurance, rent, or subscriptions.
The categorisation of these components on the balance sheet of a company is typically under the “Current Assets” section. Current assets represent assets that are expected to be converted into cash or used up within one year from the reporting date. They are listed in the order of their liquidity, with the most liquid assets (like cash and cash equivalents) appearing first.
For example, a simplified structure of the balance sheet might look like this:
- Cash and Cash Equivalents
- Short-term Investments
- Accounts Receivable
- Prepaid Expenses
These items, in total, represent the gross working capital of a company. They play a crucial role in assessing a company’s short-term financial health and its ability to meet its immediate obligations and operational requirements.
Examples of gross working capital
Before we delve into certain working capital examples, it’s important to take into account the sources of working capital:
- Funds, easily available in the market, include bills payable, creditors, trade credit, and notes payable.
- Short-term working capital includes bill discounting, bank overdrafts, cash credit, commercial paper, and inter-corporate loans and advances.
Considering that there’s a significant cost attached, experts don’t advise people to lock in huge amounts in the working capital cycle. For example, while a high inventory will look good on paper for the short term, there will be a negative impact, if the inventory remains unsold and becomes obsolete.
Advantages of gross working capital
In this section, we’ll explore the positive impact of gross working capital on the liquidity and operations of a company:
- Sustainability of daily operations: Gross working capital enables a company to carry out its daily operations seamlessly. As a business owner, when you have enough working capital at hand, it helps in making easy and timely purchases of raw materials. You can continue production without disruptions and delivery of goods and services on time. Moreover, it plays an important role in maintaining the supply chain.
- Effective management of liquidity: You can take the help of gross working capital to maintain liquidity. It’ll help you to understand whether there are enough current assets to fulfil short-term financial obligations such as paying salaries on time, paying suppliers, and managing daily expenses.
- Fulfil short-term financial obligations: Gross working capital helps you ensure that your business has the financial resources to clear its short-term debt, manage accounts payable, and pay both creditors and suppliers on time. Thus, it helps you to preserve the reputation of your business and build strong relationships.
- Stability and sustainability: Maintaining a healthy gross working capital position enhances the stability and sustainability of a business, reducing the risk of insolvency due to cash flow problems.
- Negotiation leverage: A strong gross working capital position provides leverage in negotiations with suppliers or creditors. It might allow for better terms, discounts for early payments, or improved credit terms.
Gross working capital vs. net working capital
The following table provides the differences between gross working capital and net working capital:
|Parameters||Gross Working Capital||Net Working Capital|
|Value||Positive||Can be either negative or positive|
|Calculation||Summation of a company’s current assets||Differences between the current assets and current liabilities of a business|
|Indicator of a company’s financial health||May not be a true indicator of the short-term financial position of a company||Provides a more detailed picture of the operational efficiency of a company|
It must be noted that between gross working capital and net working capital, it’s the latter that offers a clearer picture of the short-term financial health and operational efficiency of a company.
Net working capital helps people understand how well a company can manage its liabilities with its financial resources in the short run. How, you may ask. Here’s an example:
Suppose the financial statements of a business show trade receivables as Rs. 2 lakh, inventory as Rs. 4 lakh, and cash/cash equivalent as Rs. 1 lakh. By adding up these figures, we would get the gross working capital as Rs. 7 lakh. Suppose it was Rs. 5 lakh in the previous year.
It’s natural to take a look at these figures and quickly conclude that the company’s financial performance is good. But, what if its current liabilities were Rs. 2 lakh in the previous year and Rs. 3.5 lakh in the current year?
If such is the situation, we would understand that while the gross working capital of a company has grown, its net working capital has reduced in comparison to the previous year.
How to calculate net working capital?
The formula for calculating net working capital is as follows:
Net Working Capital = Total Current Assets – Total Current Liabilities
Check out the steps to calculate net working capital:
Step 1: Check the financial statements and annual reports and gather all the necessary information.
Step 2: Identify all the current assets. These will be liquid assets including receivables, cash, inventory, prepaid expenses, and every investment made for the short term.
Step 3: Identify all the current liabilities that have to be settled within a year or the normal operating cycle such as short-term debts, accounts payable, and accrued expenses.
Step 4: Finally, use the aforementioned formula to arrive at the correct value of the net working capital.
Let’s consider a hypothetical example for “ABC Manufacturing Co.” to illustrate gross working capital and net working capital.
ABC Manufacturing Co.’s Current Assets:
1. Cash and cash equivalents: Rs. 5,00,000
2. Accounts receivable: Rs. 3,00,000
3. Inventory: Rs. 8,00,000
4. Short-term investments: Rs. 2,00,000
5. Prepaid expenses: Rs. 1,00,000
ABC Manufacturing Co.’s Current Liabilities:
1. Accounts payable: Rs. 4,00,000
2. Short-term debt: Rs. 1,50,000
3. Accrued expenses: Rs. 1,00,000
Gross Working Capital: Adding all the current assets gives the gross working capital:
Rs. 5,00,000 (cash) + Rs. 3,00,000 (accounts receivable) + Rs. 8,00,000 (inventory) + Rs. 2,00,000 (short-term investments) + Rs. 1,00,000 (prepaid expenses) = Rs. 19,00,000
Net Working Capital: Subtracting the total current liabilities from the total current assets provides the net working capital:
Rs. 19,00,000 (current assets) – (Rs. 4,00,000 accounts payable + Rs. 1,50,000 short-term debt + Rs. 1,00,000 accrued expenses) = Rs. 19,00,000 – Rs. 6,50,000 = Rs. 12,50,000
In this example:
– Gross Working Capital for ABC Manufacturing Co. amounts to Rs. 19,00,000, representing the total value of their current assets.
– Net Working Capital for ABC Manufacturing Co. equals Rs. 12,50,000, indicating the excess of current assets over current liabilities. This positive net working capital suggests the company has enough short-term assets to cover its short-term obligations in the amount of Rs. 12,50,000.
Understanding the concept of gross working capital is fundamental in assessing a business’s financial well-being. It represents the aggregate value of a company’s current assets that can readily be converted into cash within a 12-month period. However, relying solely on gross working capital doesn’t provide a comprehensive insight into a company’s liquidity. It’s essential to also consider net working capital for a more complete understanding of its financial health.
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