Concept of Working Capital: Gross and Net Working Capital

There are two concepts or senses used for working capital.

These are:

1. Gross Working Capital

2. Net working Capital

1. Gross Working Capital:

The concept of gross working capital refers to the total value of current assets. In other words, gross working capital is the total amount available for financing of current assets. However, it does not reveal the true financial position of an enterprise. How? A borrowing will increase current assets and, thus, will increase gross working capital but, at the same time, it will increase current liabilities also.

As a result, the net working capital will remain the same. This concept is usually supported by the business community as it raises their assets (current) and is in their advantage to borrow the funds from external sources such as banks and the financial institutions.

In this sense, the working capital is a financial concept. As per this concept:

Gross Working Capital = Total Current Assets

2. Net Working Capital:

The net working capital is an accounting concept which represents the excess of current assets over current liabilities. Current assets consist of items such as cash, bank balance, stock, debtors, bills receivables, etc. and current liabilities include items such as bills payables, creditors, etc. Excess of current assets over current liabilities, thus, indicates the liquid position of an enterprise.

The ratio of 2:1 between current assets and current liabilities is considered as optimum or sound. What this ratio implies is that the firm/ enterprise have sufficient liquidity to meet operating expenses and current liabilities. It is important to mention that net working capital will not increase with every increase in gross working capital. Importantly, net working capital will increase only when there is increase in current assets without corresponding increase in current liabilities.

Thus, in the form of a simple formula:

Net Working Capital = Current Assets-Current Liabilities