Capital is the lifeline of every business. Any company, large or small, needs capital to finance every step of its operations, be it for the short-run or long-run. Working capital is what an enterprise pours into its daily operations. Naturally, working capital services as a reliable indicator of a business’s financial health. In this post, we will look at the difference between working capital and net working capital.
Working Capital Explained
Working capital can denote current assets alone (in which case it is sometimes known as gross working Capital) or, more commonly, Current Assets minus Current Liabilities. It is a measure of a company’s total financial resources. Working capital is calculated by totaling a business’s current assets like marketable securities, cash, short-term investments, accounts receivable, and inventory. Sometimes liabilities are not taken into consideration when determining a business’s gross working Capital, and in this regard, gross working capital only provides a limited picture of a company’s financial position. Let us say a business takes out a $300,000 loan to fund its expansion. It might currently have $300,000 on the books, which will add to its total assets and accelerate its gross working Capital. Nonetheless, that loan will also add to its current liabilities, which are not reflected in gross working Capital.
What is Net Working Capital?
Net Working Capital often refers to Current Assets minus Current Liabilities; however, it can also exclude financing items, so it is Cash + Inventory+ Trade Receivables + Marketable Securities – Trade Payables; and it ignores items such as Notes Payable, Current Portion of Long Term Debt and Taxes Payable. Some people would also include Prepaid Expenses and deduct Accrued Expenses from Net Working Capital; other people would not.
What is the difference between working capital and net working capital?
Whereas both focus on obligations due within a year, thus excluding fixed assets/PP&E (which together make up total capital), they really have two almost opposite implications and meanings. From a strict accounting perspective, basic working capital is current assets (cash, inventory, a/r) deduct current liabilities (a/p, short term debt). This essentially represents a business’s liquidity or the ability to meet short term demands. The higher the working capital, the better or more liquid.
Net working capital is similar; however, it removes the cash and debt consideration and simplifies the formula to a/r and inventory deduct a/p. This represents how much capital is needed to run the operations of the business. In this situation, the lower the number, the better as that means it takes up less capital (i.e., money) to run the daily operations. The company is being more efficient. Less capital required equates to less shareholders and creditors to pay. This definition has become much more prominent in the last decade with businesses, and often when they talk about working capital, they are actually referring to this definition, not the former.
For further comparison, in the first case having a higher a/r is a good thing as that indicates you have more money coming your way in the near term. In the latter example, it is a bad thing since that means your clients are taking too long to pay you. (Vice versa for a/p) In the former scenario, higher inventory is good as that means you are holding onto the higher value; in the latter scenario, high inventory is bad as that means the company is not managing inventory effectively by purchasing too much and thus tying up capital in the process.
Subsequently, one may also ask, what is the difference between the working capital gap and net working capital? The working capital gap, in simple words, is the difference between total current assets and total current liabilities other than a bank. It can also be defined as Long term sources less long term uses. The net capital gap is long term sources of the company less long term uses of the company.
What is the difference between working capital and capital?
The primary difference between fixed capital and working capital is that Fixed Capital is the capital which is invested by the company in procuring the fixed assets required for the working of the business, whereas working capital is the capital which is needed for the company for the purpose of financing its day to
What is the importance of net working capital?
Net working capital is essential since it gives an idea of a business’s liquidity, and if the company has enough money to fund its short-term obligations. When the net working capital figure is zero or greater, the business can cover its current obligations. Typically, the larger the net working capital figure is, the better prepared the business is to fund its short-term obligations. At all times, companies should have access to sufficient capital to cover all their bills for a year.
Net working capital is most useful when used to compare how the figure changes over time, so you can establish a trend in your business’s liquidity and see if it is improving or declining. If your company’s net working capital is substantially positive, that is a good sign; you can meet your financial obligations in the future. If it is substantially negative, that suggests your business can not make its upcoming payments and might be in threat of bankruptcy.
Net working capital can also indicate how quickly a company can grow. If a company has significant capital reserves, it might be able to scale its operations quite quickly, by investing in better equipment, for example. Whereas net working capital is a dollar amount and is essential to track, current assets’ ratio to current liabilities tells more about a company’s liquidity condition.
What is the importance of the working capital ratio?
The cash-flow cycle of a company from inventory to receivables to cash is not always perfect and steady. Managers can never be entirely sure that they will consistently have sufficient cash available to pay their bills. On the contrary, the due dates and amounts of current liabilities are well defined. Creditors expect payments on particular due dates, without exception.
Therefore, businesses try to maintain an amount of current assets that are well in excess of current liabilities. Typically, most managers try to maintain a working capital ratio of 2:1. In simple words, they want to have two dollars in current assets for every dollar in current liabilities. When the working capital ratio decreases below 1:1, the business will have difficulties meeting its debt obligations on time, so a higher current ratio is better for maintaining sufficient liquidity.
Weaknesses in Interpreting the Working Capital Ratio
Even if a business might have a high working capital ratio, it does not necessarily indicate that the company has a strong liquidity position. For instance, there might be some products in inventory that are unsalable, old, and obsolete. These items will not be contributing to the business’s cash flow. Also, Accounts Receivable could have amounts due from late or, worse, not even collectible clients. In either case, further analysis of the quality of inventory and receivables would be vital to determine the company’s real working capital position.
How to increase your working capital?
Companies can try to speed up their cash-flow conversion cycle and increase working capital with the following methods:
- Be more aggressive in the collection of unpaid receivables.
- Shorten credit payment terms to customers.
- Lower inventory levels by utilizing just-in-time purchases.
- Request suppliers to extend their accounts payable terms.
- Clean out utilized inventory by returning to suppliers or selling at discounts.
Every business requires sufficient working capital to meet its short-term financial commitments on a timely basis. The working capital ratio should be high enough to offer reserves to take advantage of opportunities when they appear and to weather financial downturns. Since a company’s cash-flow conversion cycle is not always steady, maintaining a comfortable working capital scenario is essential for the long-term survivability and growth of a business.
How to improve your net working capital?
Small businesses can make certain changes, often similar to those discussed above, to their operations if they want to improve their net working capital. Specific adjustments to improve net working capital include:
- Modify your payment terms to shorten your billing cycle and make sure your customers pay you more frequently for your services and goods
- Be diligent about following up with customers as soon as an invoice is due, so you can collect late payment more faster
- Return inventory that you haven’t used to your vendors so that you can obtain a refund for the cost
- Increase the payment period for your vendors, if they will allow it without charging late fees
In conclusion, note that analyzing your business financial health, though, is more than just identifying working capital and net working capital. The nature and level of working capital is based on the industry your business operates in or how the working process with suppliers and customers.