Assessing the need and usefulness of working capital is crucial for entrepreneurs. Such funds ensure smooth daily operations, allowing companies to bear their short-term liabilities with ease. From employee salary to supplier payments, working capital is necessary for each step.
Working capital is the equivalent of liquidity, which a business can deploy readily. It is the difference between a business organisation’s current asset and current liabilities/debts. Working capital is classified into two major divisions, gross working capital and net working capital.
A business’s working capital serves as its indicator, which monitors how seamlessly it operates and its short term financial stability.
Businesses need to ensure that they never run out of working capital. Sufficient working capital also allows a business to make quick client payments and thereby increase its goodwill.
What is gross and net working capital?
The total of a company’s current assets is its gross working capital. In contrast, net working capital is the actual difference between the total of its current assets and its total current liabilities.
For new and small businesses, a guide to working capital loans is essential to understand the importance of working capital loans and how the loan can be helpful for the overall business performance. Available in simple steps, owners of new or small businesses through this loan can purchase new raw materials and meet other business needs thereafter.
Key differences between net and gross working capital
- What they mean
While gross working capital shows a company’s total capital in hand for financing current assets, net working capital indicates its eligibility in managing the total expenses against its current liabilities.
- Values of net-working and gross working capital
Gross working capital is always positive. On the other hand, the net working capital keeps fluctuating between positive and negative.
The working capital ratio or current ratio is a critical metric that indicates the relationship between current assets and current liabilities.
Working Capital Ratio or Current Ratio = Current Assets/Current Liabilities
The current ratio determines the net working capital requirement, and the ideal value is always 2:1.
Current ratio >1 = Positive net working capital
Current ratio <1 = Negative net working capital
Current ratio equal to 1 = Zero net working capital
For example, if a business’s current assets stand at $2 million and current liabilities of $1.5 million, the current ratio is 1.33
A working capital ratio between 1.2 and 2 indicates a healthy cash flow to clear debts but not adequate for the longer run. A ratio below 1 is negative, implying that the business is struggling to maintain itself. Above 2 indicates extra cash and can be reinvested.
- Projecting financial situation of a company
While the gross working capital does not reveal a company’s financial position, net working capital shows its current financial position upfront.
- Factors affecting working capital
Gross working capital increases when a company’s borrowings increase, unlike the net working capital, increasing only when the company’s total profit and total sale of assets increases.
The concept of net working capital is preferable for partnership or sole-trade firms. But, gross working capital is best suited for private limited companies and public limited companies, a form of organisation with a distinction between ownership, management and control.
Businesses with large working capital needs can apply for a business loan to avail liquidity during times of cash crunch. This is helpful during seasonal differences in cash flow and can clear obligated funds to suppliers and employees while waiting for customer payments.
Financial institutions like Bajaj Finserv provide pre-approved offers to accelerate loan approvals while also simplifying them. These offers are available on a range of financial products, such as personal loans, business loans and more. One can check his/her pre-approved offer by submitting your name and phone number.
Proper working capital management is directly proportional to a business’s earnings and profitability. It is a reflection of a company’s various activities such as inventory management, debt management, revenue collection and more. The better the working capital, higher the profit margin for an enterprise.