Working Capital Approaches
Working capital measures a company’s operational efficiency and short-term financial health. It is calculated as the difference between current assets and current liabilities. Various approaches to computing working capital offer insights into different aspects of financial management:
- Net Working Capital Approach
- Gross Working Capital Approach
- Working Capital Cycle Approach
1. Net Working Capital Approach
Net working capital (NWC) measures a company’s liquidity and its ability to meet short-term obligations with short-term assets.
Formula:
Net Working Capital = Current Assets − Current Liabilities
Example: Consider a company with the following balance sheet items:
- Cash: $20,000
- Accounts Receivable: $50,000
- Inventory: $30,000
- Accounts Payable: $40,000
- Short-term Loans: $10,000
Net Working Capital = (20,000 + 50,000 + 30,000) − (40,000 + 10,000) = 100,000 − 50,000 = 50,000
The company’s net working capital is $50,000.
2. Gross Working Capital Approach
Gross working capital refers to the total of all current assets. This approach focuses on the firm’s investment in short-term assets, emphasizing the company’s ability to cover its short-term financial needs.
Formula: Gross Working Capital = Total Current Assets
Example: Using the same balance sheet items from the previous example:
Gross Working Capital = 20,000 + 50,000 + 30,000 = 100,000
The company’s gross working capital is $100,000.
3. Working Capital Cycle Approach
The working capital cycle (WCC) measures the time it takes for a company to convert its net working capital into cash. It is an important indicator of operational efficiency.
Formula: WCC = Inventory Period + Receivables Period − Payables Period
Where:
- Inventory Period: The average time inventory is held before sale.
- Receivables Period: The average time to collect receivables.
- Payables Period: The average time to pay suppliers.
Example: Suppose a company has the following average periods:
- Inventory Period: 30 days
- Receivables Period: 45 days
- Payables Period: 25 days
WCC = 30 + 45 − 25 = 50 days
The company’s working capital cycle is 50 days, indicating it takes 50 days to convert its working capital into cash.
Numerical Problems
Problem 1: Net Working Capital Calculation
Scenario: A company has the following current assets and liabilities:
- Cash: $15,000
- Accounts Receivable: $25,000
- Inventory: $35,000
- Accounts Payable: $20,000
- Short-term Loans: $5,000
- Accrued Expenses: $10,000
Solution: Net Working Capital = (15,000 + 25,000 + 35,000) − (20,000 + 5,000 + 10,000) = 75,000 − 35,000 = 40,000
The company’s net working capital is $40,000.
Problem 2: Gross Working Capital Calculation
Scenario: A company’s current assets include:
- Cash: $10,000
- Accounts Receivable: $20,000
- Inventory: $15,000
- Marketable Securities: $5,000
Solution: Gross Working Capital
=10,000 + 20,000 + 15,000 + 5,000 = 50,000
The company’s gross working capital is $50,000.
Problem 3: Working Capital Cycle Calculation
Solution:
Step 1: Calculate Inventory Period
![\[\text{Inventory Period} = \left( \frac{\text{Average Inventory}}{\text{COGS}} \right) \times 365\]](https://bbaguru.in/wp-content/ql-cache/quicklatex.com-05d060134708646b54cee60e9e92da33_l3.png "Rendered by QuickLaTeX.com")
![\[\text{Inventory Period} = \left( \frac{40{,}000}{360{,}000} \right) \times 365 \approx 40.56 \text{ days}\]](https://bbaguru.in/wp-content/ql-cache/quicklatex.com-bf83c353d377de7685296237b3607a4f_l3.png "Rendered by QuickLaTeX.com")
Step 2: Calculate Receivables Period
![\[\text{Receivables Period} = \left( \frac{\text{Average Accounts Receivable}}{\text{Net Credit Sales}} \right) \times 365\]](https://bbaguru.in/wp-content/ql-cache/quicklatex.com-566cc13342195889c83ba02ee80f0b12_l3.png "Rendered by QuickLaTeX.com")
![\[\text{Receivables Period} = \left( \frac{30{,}000}{300{,}000} \right) \times 365 = 36.5 \text{ days}\]](https://bbaguru.in/wp-content/ql-cache/quicklatex.com-490763ed16d141cc1d99f8126e909769_l3.png "Rendered by QuickLaTeX.com")
Step 3: Calculate Payables Period
![\[\text{Payables Period} = \left( \frac{\text{Average Accounts Payable}}{\text{Annual Purchases}} \right) \times 365\]](https://bbaguru.in/wp-content/ql-cache/quicklatex.com-07f441a588e7bce9b19c578d834f2020_l3.png "Rendered by QuickLaTeX.com")
![\[\text{Payables Period} = \left( \frac{20{,}000}{240{,}000} \right) \times 365 \approx 30.42 \text{ days}\]](https://bbaguru.in/wp-content/ql-cache/quicklatex.com-eae27226662b53fe434ba4fcd35e2295_l3.png "Rendered by QuickLaTeX.com")
Step 4: Calculate Working Capital Cycle (WCC)
![\[\text{WCC} = \text{Inventory Period} + \text{Receivables Period} - \text{Payables Period}\]](https://bbaguru.in/wp-content/ql-cache/quicklatex.com-39e85758a0e6ec5be3d6b6edd85287a5_l3.png "Rendered by QuickLaTeX.com")
![\[\text{WCC} = 40.56 + 36.5 - 30.42 = 46.64 \text{ days}\]](https://bbaguru.in/wp-content/ql-cache/quicklatex.com-ef94956e628dc58aedd1a25d46bf6cb6_l3.png "Rendered by QuickLaTeX.com")
✅ Final Answer:
The Working Capital Cycle is approximately 46.64 days, meaning it takes around 47 days to convert working capital into cash.