What is Net Concept of Working Capital?

Finance ManagementBanking & FinanceGrowth & Empowerment

Definition: Net Concept of Working Capital

The net concept of working capital is a qualitative concept that focuses on the liquidity of funds that must be maintained in order to meet short-term liabilities. It is obvious that a company would need enough funds to meet the day-to-day needs of its operation, so that it can survive and meet its long-term goals. The net concept of working capital management should be applied to organizations individually as there is no precise measure to which the net concept of working capital management should be applied to a company.

Like the gross concept of working capital management, the net concept also looks into managing working capital to an optimum extent. However, net and gross concepts cover different aspects of financial management and hence should be separated from each other.

Role of Current Assets and Liabilities in Net Working Capital

The short-term financial needs of a company are referred to as current assets and current liabilities. While current assets refer to funds that can be converted to cash within a short span of time, the current liabilities refer to payments that are due within a year. Both current assets and current liabilities are important factors for a company.

Maintain balance to an Optimum Position

A company that needs to survive and grow, must balance current assets and current liabilities to an optimum position. Usually, current assets must be enough to meet the current liabilities for a company to sustain its growth. It is sometimes quoted by financial analysts that current assets must be twice that of current liabilities at all instances for a company to remain in a good financial condition.

Requirement of enough current assets

A weak financial position is considered a threat to the insolvency of the company. If a company fails to manage its current liabilities with its current assets, a threat of bankruptcy looms large over it. That is why it is considered good to have enough current assets in comparison to current liabilities for the investors. Therefore, it is obvious that in order to maintain liquidity, the company should have enough current assets.

Access of Current Assets

It is to be noted here that too much of current assets is also a bad sign. Too much of current assets is a sign of mismanagement and it must be rectified as soon as possible. While too less of working capital is disastrous, so are the situations of too much working capital.

Role of Long- and Short-Term Funds in Net Working Capital

As the investment decision lies with the management, and as the management has the idea of its working capital structure, they must decide the extent up to which the current assets must be financed by equity capital and/or borrowed capital.

Right Mix of Long and Short-Term Funds

The net concept of working capital also focuses on the right mix of long and short-term funds for financing current assets. Every company has a minimum amount of permanent net working capital. Therefore, a part of working capital should be financed by this permanent working capital, using equity, debentures, long-term debt, preference shares, and retained earnings.

Efficient Working Capital Management

Like the gross concept of working capital, the net concept also provides ideas for using efficient working capital management. As there is no exact manner in which the perfect amount of net working capital can be found without going deep into the financials, the management of companies must analyze the data available to reach an agreeable position of net working capital that is perfect for the company. It is, therefore, obvious from the net concept of working capital that the judicious mix of short and long-term funds goes a long way in building the overall structure of working capital management.

Conclusion

In the above ways, we can conclude that it depends on the financial status and requirements of an organization to which the net concept should be applied to get a holistic solution for managing working capital.

raja
Updated on 30-May-2022 12:10:06

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