Breakdown of the notions of net and gross working capital

Capital is the engine of all enterprises. When properly managed, it keeps the lights on and the wheels turning. But what is working capital? In simple terms, it is funding provided to meet day-to-day operational costs. Without it, business would probably stop. Working capital is calculated in two categories, net and gross working capital, each used to measure a different aspect of business finance. Both are essential parts of the capital structure, and good entrepreneurs strive to keep working capital in healthy reserves.

Many believe that working capital is a key indicator of a company’s financial health. This makes sense given that it not only funds day-to-day operations, but also clears the company’s debts. As an entrepreneur, you need to know the distinction between the two categories, how they are calculated, and how to interpret them effectively. Here’s what you need to know about net and gross working capital and their differences.

Gross working capital

This type of working capital is simply a measure of all assets currently held by the business. Generally, only assets that can be converted to cash in less than a year can be classified under the gross working capital umbrella. This means that it is a representation of the company’s short-term liquid resources. Some of the assets eligible for this type of working capital include:

Cash

Debtors

Inventory

Securities

Prepaid expenses

Accounts Receivable

short term investments

With an idea of ​​this cash, you can calculate gross working capital using this simple formula:

Gross working capital = Trade receivables + Inventories + Marketable securities + Cash and cash equivalents + Prepaid expenses

Note that using gross working capital to assess operational efficiency is not a valid approach. Indeed, this value is always positive and will therefore provide an inflated interpretation. It does not take into account any liabilities of the company. However, knowing this value offers insight when assessing the financial health of the business.

Net working capital

Unlike gross working capital, this accounting concept takes into account the company’s current liabilities in its calculation. It is therefore a reliable measure of the stability and operational efficiency of the company. For this reason, it is also commonly referred to as working capital. Entrepreneurs must rely on net working capital to gauge the liquidity and health of the business. Calculating this value is easy to do, but first you need to know the factors that make up current liabilities. Generally, these are:

Accounts payable

Short term loan

Taxes

Customer deposits

Creditors

Long-term debts that will mature in one year

Once you have accounted for all liabilities, you can calculate net working capital using this formula:

Net working capital = current assets – current liabilities

Note that net working capital can be negative or positive. Ideally, your business should maintain a positive ratio of assets to liabilities, which is 2:1. This indicates that the assets can comfortably accommodate the liabilities, thereby mitigating the risk of insolvency. Conversely, a negative ratio implies that liabilities outweigh assets and the company may not be able to meet its credit.

Difference Between Net and Gross Working Capital

Take a look at the following table to see the clear differences in how they are calculated and how they should be interpreted.

With a better idea of ​​the differences between net and gross working capital, you are in a better position to interpret the financial situation of your business. It also provides insight into the importance of maintaining a healthy net working capital. With adequate levels, you can overcome downturns and consider investing in growth as well. To complement your efforts, consider the Bajaj Finserv working capital loan for business financing.

It’s easy to use, requires minimal documentation, and comes with a hassle-free application process. With it, you can access capital of up to Rs.45 lakh to bolster your cash flow or work towards expansion. The loan also has an accelerated disbursement time as you can get approved within hours. To take advantage of these benefits and more, check out your pre-approved offer today.