The term working capital is commonly used for the amount required for holding current assets like stock of raw material and finished goods, bills receivable, debtors and cash and also to meet the day to day expenses like salareis and wages, rent, taxes etc. The term working capital is used in two senses – Gross working capital and net working capital.
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The Gross Working Capital refers to the firm’s total investment in current assets. Current assets mean assets which can be converted into cash within an accounting year. According to J.S. Mill, “the sum of the current assets is working capital of a business.”
The Net Working Capital of a business represents the excess of current assets over current liabilities. Current liabilities include trade creditors, bills payable, bank overdraft and outstanding expenses. These are expected to mature for payment within as accounting year. We may put the concept of net working capital in the following equation–
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Net Working Capital = Current assets – Current liabilities
Net working capital can be positive or negative. A positive net working capital arises when current assets exceeds current liabilities and a negative working capital occurs when current liabilities are in excess of current assets. Normally, the current assets are in excess of current liabilities in a business. Normally, the current ratio i.e., ratio of current assets to current liabilities of 2:1 is considered good and it is a sign of soundness of the business.
If we study the above two concepts – Gross and Net – of working capital, we find that the two concepts may be designated as ‘quantitative’ and ‘qualitative’ aspect of working capital. Both concepts have equal importance from management point of view. The gross working capital concept focuses attention on two aspects of current assets management – (a) optimum investment in current assets and, (b) financing of current assets. The net working capital concept (a) indicates the liquidity position of the firm, and (b) suggests the extent to which working capital needs may be financed by permanent sources of funds. Short term creditors would always like a positive net working capital because it would be an extra security for their loan.
Working capital can be classified in two ways.
- On the Basis of Concept
- On the Basis of Periodicity of its requirements.
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On the Basis of Concept: On the basis of its concept, the working capital may be divided into gross working capital and net working capital. Gross- working capital is represented by the total current assets and the net working capital is the excess of current assets over current liabilities. Net working capital can be positive or negative. If current assets are in excess of current liabilities, it is positive net working capital and if total current liabilities exceed total current assets, it is negative been explained earlier in this question under the ‘Meaning of working capital’.
On the Basis of Periodicity of Requirements: According to this classification, working capital can be classified into (i) Fixed or Permanent working capital, and (ii) Variable working capital.