1. What is Working capital?
To run a company, to fund its basic trading operations like purchase of raw
material, production of goods, to pay off wages, to sell produced goods, business
needs funds.
And working capital means, the fund that is/ that should be available to
the business, to meet its above mentioned operational expenses, until the
company collects receipts from the customers for the sales previously
made.
In a common man's terms, it is the money that should be available, for
meeting his urgent financial needs.
What is Gross Working capital then?
It is sum total of the current assets of organization. In financial
terms, it is the total amount available for financing of
current assets.
so, what is current asset? : Current assets represents the
value of all trade assets that can be consumed, sold, or converted into
cash within a year.
eg Cash in hand, bank balance, cash equivalents like Treasury bills,
Receivables, short term investments, prepaid expenses etc
The Gross working capital concept does not consider the current liabilities
in picture and is a book term rather than a practical concept used for
assessment of financial needs.
Then what is net working capital?
Net working capital is the difference between current assets and
current liabilities. It is one among the reliable indicator of liquidity
status of the company, since it takes into account the financial obligations as
well of the company (ie current liabilities)
so, what is current liability? Current liabilities represents
trade obligations that are expected to be settled/paid off within a year.
eg Trade creditors, outstanding expenses, short term loans availed etc
Lending institutions adopt ' Net working capital' approach, to assess the
financial requirements of the borrower.
Positive working capital.
-when the company's Current assets are more than current liabilities, it is
said to have a positive working capital.
-Positive working capital indicates that business has sufficient
liquid assets to pay off its short term financial obligations and
reflects on company's good financial position.
- But some situations, it also indicates an unfavourable financial position.
Signifying operational inefficiency like a) too much of funds are locked
in business in the form of excess Inventory. (non moving, obsolete) b)
Long outstanding in debtors might be indicative of lower chance of its
collection. c) Idle funds costing a higher opportunity cost.
Negative working capital:
-Excess of current liabilities over current assets is known as negative of
working capital.
-while a temporary negative working capital might not be an alarming
situation, but a negative working capital steadily over long term, means that,
the resources of the company even after realisation of current assets, is
not sufficient enough to pay its debts and effectively operate the
company.
It is NOT a good sign of solvency of business.
- BUT, In special scenarios and in specific business like as in retail
biz and cash-only sale businesses, the have negative working capital and is
considered a favourable financial situation.
Example Cases like
a) where there is usually quick movement of FG stock
b) where the business generates cash quickly - customers pay on the
spot (quick collection) even before invoices on supplies made by
creditors/vendors becomes due.
c) better bargaining power (in terms of credit period) the business enjoys
from its suppliers and thereby funding growth in sales, by effectively
availing credit from vendors.