Definition
Total current assets are referred to as gross working capital. In the hypothetical absence of any liabilities, gross working capital has no reason to be maintained.Hence, for a meaningful study, current liabilities have to be considered in comparison with current assets, the difference (excess of current assets over current liabilities) being defined as the net working capital (NWC). Yet, in practice, a more usefil definition of NWC has been evolved as under. Current liabilities represent sources of short-term funds. In such a context, if current assets have to exceed current liabilities, the excess must be financed by long-term funds.
Accordingly, an alternative, and practically more useful, definition of NWC is :NWC is that portion of a firm's current assets which is financed with long-term funds.When discussirig liquidity ratios in Unit 19, two ratios, current ratio and acid-test ratio were studied, and a non-ratio, viz. NWC, was also studied. The ratios are more pertinently useful in comparing liquidities between firms. NWC, on the other hand, though not useful in comparing the performance and the liquidity of different firms, is yet quite useful for internal control within the (a single) firm, particularly to trace its liquidity chronologically, i.e. over time. Thus, NWC is a more workable definition of liquidity for discussing the management of WC. Said otherwise, the content of study of WC management is to manage the current assets and liabilities in such a way that an acceptable level of NWC is maintained.
Implications
The theoretical justificationlneed for a firm to operate with some quantum of NWC is, that, if this safety margin, or liquidity, is greater, the more is the ability of the firm to meet its immediate obligations. Since cash outflows are not likely to be matched instant-to-instant by like cash inflows, or for that matter since demands for inventory are not likely to be all the time matched with like availability of inventory, there arises the need to maintain a certain amount of NWC. In essence, we de-couple the demands from the supplies by keeping a buffer, or a margin.Even if demand of cash outflows or inventory needs be predictable, it is unlikely that the cash inflows or inventory supplies can be assuredly predicted. The more this latter unpredictability, the greater the NWC needed.
Total current assets are referred to as gross working capital. In the hypothetical absence of any liabilities, gross working capital has no reason to be maintained.Hence, for a meaningful study, current liabilities have to be considered in comparison with current assets, the difference (excess of current assets over current liabilities) being defined as the net working capital (NWC). Yet, in practice, a more usefil definition of NWC has been evolved as under. Current liabilities represent sources of short-term funds. In such a context, if current assets have to exceed current liabilities, the excess must be financed by long-term funds.
Accordingly, an alternative, and practically more useful, definition of NWC is :NWC is that portion of a firm's current assets which is financed with long-term funds.When discussirig liquidity ratios in Unit 19, two ratios, current ratio and acid-test ratio were studied, and a non-ratio, viz. NWC, was also studied. The ratios are more pertinently useful in comparing liquidities between firms. NWC, on the other hand, though not useful in comparing the performance and the liquidity of different firms, is yet quite useful for internal control within the (a single) firm, particularly to trace its liquidity chronologically, i.e. over time. Thus, NWC is a more workable definition of liquidity for discussing the management of WC. Said otherwise, the content of study of WC management is to manage the current assets and liabilities in such a way that an acceptable level of NWC is maintained.
Implications
The theoretical justificationlneed for a firm to operate with some quantum of NWC is, that, if this safety margin, or liquidity, is greater, the more is the ability of the firm to meet its immediate obligations. Since cash outflows are not likely to be matched instant-to-instant by like cash inflows, or for that matter since demands for inventory are not likely to be all the time matched with like availability of inventory, there arises the need to maintain a certain amount of NWC. In essence, we de-couple the demands from the supplies by keeping a buffer, or a margin.Even if demand of cash outflows or inventory needs be predictable, it is unlikely that the cash inflows or inventory supplies can be assuredly predicted. The more this latter unpredictability, the greater the NWC needed.
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