Gross Working Capital
vs Net working Capital
• Working capital is the
liquidity of a company and has two definitions namely gross working capital and
net working capital.
• Gross working capital is
the total of all current assets and does not hold much significance for the investors
• Net working capital is the
excess of current assets over current liabilities of a company which is why it
is an important indicator of company’s financial health.
Sources of Finance for Working Capital
Working
capital refers to the funds needed by a business to conduct its daily
operations, such as payment of wages, purchase of raw material, covering
overhead costs and offering credit services. Working capital can be subdivided
into two areas: regular working capital that provides a steady base for overall
business objectives; and short-term working capital used to facilitate the
day-to-day business operations. Sources of finance for working capital include
bank loans, retained earnings, credit from suppliers, long-term loans from
financial institutions, or proceeds from sale of assets.
Long-Term Loans
A loan is the amount of
money that is given to an individual or a company on the agreement they will
repay the amount borrowed in a period that exceeds 12 months and at
predetermined interest rates. Long-term loans are usually secured against
certain assets and are offered by commercial banks, the government and
financial institutions. This type of loan provides the long-term working
capital for the business.
Short-Term Loans
Short-term loans are loans
that are to be repaid within a year from the time they are borrowed. Savings
banks, cooperatives and the government through the Small Business
Administration are some of the institutions that offer these loans. Bank
overdraft is one such source of business finance. A bank overdraft is a
withdrawal made by a business that exceeds the amount of balance in its bank
account, although the amount of money does not exceed a set limit.
Line of Credit
This is a form of a loan
agreement between the bank and the borrower that enables the borrower to
acquire some amount of the funds on demand, but the borrower does not have to
take the loan. A business may secure working capital through this service if it
has recurring expenses at regular intervals.
Trade Credit
This credit service offered
by suppliers allows businesses to get goods and pay for them later. This is a
source of working capital that may be acquired from all suppliers depending on
the business arrangements, the type of business you conduct and the worth of
the credit to be offered.
Asset-Based Financing
A business may use its
assets to secure working capital from financial institutions that offer asset
based loans. The asset includes machinery, vehicle or accounts receivable.
Accounts receivable are financial documents of people or companies that owe
money to the business and they may be traded in to finance working capital at
discounting companies.
Inventory Financing
These loans are secured with
the business` inventory acting as the security. Finance for working capital may
be acquired through its inventory although the business cannot sell it until
the loan is repaid because the lender has the right to the inventory until the
loan has been repaid.
There
are basically three approaches to financing working capital. These are: the
Hedging approach, the Conservative approach and the Aggressive approach.
Hedging Approach: Under this approach, the
funds for acquiring fixed assets and permanent current should be acquired with
long term funds and for temporary working capital short term funds should be
used.
Conservative Approach: This approach
suggests that in addition to fixed assets and permanent current assets, even a
part of variable current assets should be financed from long-term sources. The
short-term sources are used only to meet the peak seasonal requirements. During
the off season, the surplus fund is kept invested in marketable securities.
This approach depends upon the long-term sources to a great extent.
Aggressive Approach: This approach depends
more on short-term funds. More short-term funds are used particularly for
variable current assets and a part of even permanent current assets, the funds
are raised from short term sources.
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