Gross working capital and net working capital are components of the overall working capital of a company. Overall working capital is divided into gross and net working capital in order to illustrate more clearly a company’s financial condition. Working capital doesn’t account for a company’s liabilities, whereas net working capital -- by measuring the difference between current assets and current liabilities -- is a more useful tool in determining a company’s financial health.
Working capital is calculated by subtracting a business’s current liabilities from its resources. A positive working-capital figure indicates that a company’s financial health is generally good and that it is able to pay short-term debts by selling some or all assets. A negative working capital number may mean that a company can’t meet its debt obligations, even by selling capital assets like cash, inventory and accounts receivable. In-the-red working capital could alert investors or potential investors that a company isn’t optimizing its operational effectiveness or that sales are too low.
Gross Working Capital
Gross working capital reflects the total working resources of a company. It does not take into account liabilities; it simply indicates the total resources of a business. Therefore, a working-capital figure doesn’t provide clear insight into a company’s financial situation.
Net Working Capital
Net working capital is a much truer indication of a company’s financial health. Net working capital is yielded by dividing current liabilities by current assets. It represents the excess of resources over liabilities. For example, if a company has assets of $200 and liabilities of $100, it has a net working capital ratio of 2 -- $200 in assets ÷ $100 in liabilities. Current assets include stocks, money owed by debtors -- accounts receivable -- cash and cash equivalents, and other current assets. Current liabilities include all short-term borrowings, or company debt due in the next year. Another simple formula is subtracting company liabilities from assets to arrive at a dollar figure for positive or negative net working capital. Net working capital is a good rule-of-thumb indicator of a company’s financial health, operational effectiveness and future-sales potential.
Changes in Working-Capital Theory
A company with a high working-capital total may be in financial trouble if its working-capital requirements are higher still, according to Ecofine.com, reporting on a 1999 book by French economist Marc Bertonèche and a 2010 book by French economist Ecole Hôtelière de Lausanne. In contrast, a business with a small, or even negative, working-capital figure may be financially healthy if its working-capital requirements are small. According to the newsletter “Leadership Insights,” published by R. Gaines Baty Associates, business leaders are putting long-held working-capital theories to the test. World-renowned investor and Berkshire Hathaway CEO Warren Buffet has utilized deferred taxes and “floats,” or non-company funds, as “non-perilous” leverage methods to own “far more assets than our equity capital alone would permit.”
Negative Working-Capital Approaches
Dell Computer founder Michael Dell began using a negative-working-capital approach in the 1990s, moving from a positive working-capital balance in 1996 to a severely negative working-capital total in 2002 while, at the same time, greatly reducing inventory levels and accounts receivable and increasing account payable figures. These figures may be misinterpreted as bad -- too many accounts payable, for instance -- but companies that generate cash very quickly often have negative working-capital numbers. Dell sells directly to consumers, eliminating retailers. Other companies, such as McDonald’s, also tend to operate with negative working-capital totals, with customers paying so quickly for goods and services that products are bought from suppliers and sold to customers before the company even has an opportunity to pay suppliers. This creates a misleading accounts-payable imbalance.