Capital is the life breath for all businesses, regardless of size and nature. Without adequate capital, it becomes impossible to continue the daily operation and support the growth, development, and expansion program.
Most importantly, adequate capital suggests the health of a business. For this reason, businesses take all the steps to ensure adequate capital flow. Businesses categories their working capital into net working capital and gross working capital. Each indicates specific business standing and holds respective importance for the business. The paragraphs underneath shall compare these categories and explain their importance to a business.
An overview of the Gross Working Capital
Gross Working Capital refers to the aggregated value of a business’s current assets. It includes short-term fiscal resources that feature enough liquidity for conversion into cash in lesser than a year. The tally accounts for debtors, inventory, cash, equivalents, all prepaid expenses, and exchangeable securities.
Even if it holds immense importance in evaluating a business’s fiscal health, Gross Working Capital is just a portion of the total canvas. This is why it does not include the tally for the business’s current liabilities. A business is expected to manage its current liabilities using the gross working capital in its accounts. It is for this reason that the gross working capital cannot display a negative figure.
Business experts hold the notion that it is impractical to judge a business’s fiscal health considering its gross working capital only as it is likely to produce an inflated figure for not considering the current liabilities of the business.
What is Net Working Capital?
As the gross working capital is prone to display an inflated figure for not considering the current liabilities, there is the need for a yardstick that will produce an exact standing of its financial position. It is where the Net Working Capital becomes more crucial than the gross working capital.
To compute an organisation’s Net Working capital, one needs to take into account all the current liabilities in its account. The tally should include creditors, term loans availed, maturing debt in lesser than a year, and the payable dividends within a year. The figure derived after considering all these liabilities needs to be adjusted with the Current assets at the disposal of the business, as computed in the paragraph above. The resultant figure will display the net working capital that the business can utilise to finance its daily operation.
The Net Working Capital is a more mature figure to evaluate a business’s financial health, operational efficacy, and risk and threats. Based on this figure, investors decide to invest in the company, and banks and Financial institutions consider the repayment capacity of the business for new loans and credit products.
What are the most crucial Working Capital Metrics?
The net working capital alternatively gets accounted as the working capital. It is likely to come in negative figures if the current liabilities value exceeds the current asset figure. Investors and creditors consider it healthy if a business retains positive working capital in a financial year. It implies that the organization is in solid financial health and gets administered with the optimum operational efficacy. Here are the most essential working capital metrics for any business:
Current ratio: the figure underlines between the Current assets and liabilities and gives an indication of the financial health and capital supply to run the business process. If the ratio features a figure above 1, it implies the business is cash rich to support its process and consider expansion. Ideally, the ratio has to be 2:1 between the current assets and liabilities.
Acid-Test Ratio: alternatively known as the quick ratio, it projects short-term liquidity for a business. Ideally, a business has to feature a positive acid test ratio to suggest adequate capital supply, solid financial health, and operational expertise.