Approaches to the Computation of Working Capital (with Numerical problems)
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:
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
Scenario: A company’s financial data shows:
- Average Inventory: $40,000
- Cost of Goods Sold (COGS): $360,000
- Average Accounts Receivable: $30,000
- Net Credit Sales: $300,000
- Average Accounts Payable: $20,000
- Annual Purchases: $240,000
Solution:
