What is the Concept of Working Capital? (Gross Working Capital and Net Working Capital)

Working capital is the amount of capital revolving, circulating in the short term to facilitate the daily operations of the business. It is considered the backbone of every business as it plays a very important role in the growth of the business.

That’s why financial managers give the utmost importance to working capital management for a healthy financial position of the firm.

You can say that working capital means, the company’s investment in raw material, finished goods, cash, and receivables.

For example, for any manufacturing concern, availability of raw material is important for continuous and non-stop production, a certain amount of finished goods in the warehouse are also important for a company to continue its sales without affecting by fluctuations in the production rate, likewise, the company also needs to invest in credit sales for achieving continuous sales along with cash in hand and bank balance to meet the daily cash demand.

There are two concepts of working capital.

  • Gross Working Capital:
  • Net Working Capital

Gross Working Capital

The gross working capital is the amount of a company’s total investment in current assets. Or you can say that the total amount of short-term capital needed to run the business operations is called gross working capital.

For example, the total amount of raw material, finished goods, receivables, and cash. The gross working capital has some limitations like it did not show the real position of the business.

Because if a company borrows some loans or advances, it will definitely affect the value of current assets as the bank balance will increase which will affect the working capital in a positive way but ignores the other side of the balance sheet which shows a rise in the amount of liability.  

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This concept is useful to an extent to calculate the gross amount needed to invest in current assets to run the business smoothly.

This concept is usually supported by new businesses that own the business idea but have less investment and have to borrow money from banks and other financial institutions to meet their requirement of working capital. 

Net Working Capital: 

Networking capital is the positive or negative balance of the company’s current assets over current liabilities.

In simple words, you can say that networking capital is calculated by current assets minus current liabilities.

Current assets include inventory, cash, and cash equivalents and account receivables while current liabilities include accounts payable, outstanding expenses, or short-term borrowings.  

The formula for net working capital can be defined as 

Net Working Capital = Current Assets – Current Liabilities 

Networking capital may be positive or negative depending on the values present in the current section of the balance sheet.

The result will be positive if the company has invested more in current assets supported by fewer current liabilities. And the results will be negative if the amount of current liabilities exceed the value of current assets.  

The negative working capital shows that the company business is at high risk as the business has more debt as compared to its own capital. But according to modern theories, negative working capital is not always a bad thing.

Because there are many situations where businessmen may have a good business plan but due to a shortage of funds, they may borrow a relatively high amount from banks and other financial institutions.

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Hence in this, the networking capital will be negative but you may not consider this as a case of financial management failure. Because the owner uses borrowing as a tool to start and grow their business.

And with the passage of time and hard work, if the business plan executes well, the working capital position will start moving from negative to positive.