Companies need capital to remain operational and grow, and the amount of capital a company has is a strong indicator of its financial health. Working capital can be divided into two categories: gross working capital and net working capital.
Gross working capital
Gross working capital is a measure of a company's total financial resources. Gross working capital is calculated by totaling a company's current assets such as cash, short-term investments, accounts receivable, inventory, and marketable securities. Liabilities are not taken into account when determining a company's gross working capital, and in this regard, gross working capital only offers a limited picture of a company's financial standing.
Let's say a company takes out a $300,000 loan to finance its expansion. It may currently have $300,000 on the books, which will add to its total assets and increase its gross working capital. However, that loan will also add to its current liabilities, which aren't reflected in gross working capital.
Net working capital
Net working capital provides a much more thorough, comprehensive picture of a company's financial health. Net working capital is calculated by taking a company's total current assets and subtracting any current liabilities. Current liabilities include accounts payable, short-term debt, taxes, and employee salaries. If a company takes out a short-term loan in the amount of $50,000, its net working capital won't increase, because while it is adding $50,000 in assets, it is also adding $50,000 in liabilities.
Working capital ratio
A company's working capital ratio is indicative of whether it has enough current assets to cover its short-term debt and operating expenses. The ratio is calculated as follows:
Current assets / current liabilities
A 2:1 ratio between current assets and current liabilities is generally considered ideal. A company should have enough working capital to meet its operational needs, but there is also such a thing as having too much working capital. If a company has an excessive amount of working capital, chances are that some of its current assets, such as cash, could be put to better use. Of course, if a company doesn't have enough working capital, its ability to meet its daily cash requirements will be threatened. Additionally, companies that tend to experience seasonal or cyclical peaks may require more working capital than those that do steady business all year round.
Ways to increase working capital
Companies lacking in working capital can take steps to increase it by altering their invoice terms so that customers must remit payment within a shorter period of time. They can also work on extending their accounts payable terms so as to retain more cash on hand at any given point in time.
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