What are the Components of Working Capital?
Major components of working capital are its current assets and current liabilities and the difference between them makes up the working capital of a business. Current Assets majorly comprise of trade receivables, inventory, and cash & bank balances and current liabilities majorly comprise of trade payables. The efficient management of these components not only ensures the profitability of the business but also ensures the smooth running of the business.
4 Main Components of Working Capital
- Trade ReceivablesTrade ReceivablesTrade receivable is the amount owed to the business or company by its customers. It is also known as account receivables and is represented as current liabilities in balance sheet.
- Cash and Bank Balances
- Trade Payables
Let us discuss each of them in detail –
#1 – Trade Receivables
- Trade Receivables form a significant part of the current assetCurrent AssetCurrent assets refer to those short-term assets which can be efficiently utilized for business operations, sold for immediate cash or liquidated within a year. It comprises inventory, cash, cash equivalents, marketable securities, accounts receivable, etc. and, therefore, working capital. It also includes the amount due to the bills of exchangeBills Of ExchangeBills of exchange are negotiable instruments that contain an order to pay a certain amount to a particular person within a stipulated period of time. The bill of exchange is issued by the creditor to the debtor when the debtor owes money for goods or services. receivable. These are the amount in which the business is owned by its customers. A crafted receivables management policy goes a long way in ensuring timely collection and avoidance of bad debtsBad DebtsBad Debts can be described as unforeseen loss incurred by a business organization on account of non-fulfillment of agreed terms and conditions on account of sale of goods or services or repayment of any loan or other obligation., if any, for the business.
- Each industry has a specific trade cycle, and businesses must ensure to keep their trade receivable cycle in line with the industry. A more extended trade receivable period will result in a delayed collection of cash, impacting the cash conversion cycleCash Conversion CycleThe Cash Conversion Cycle (CCC) is a ratio analysis measure to evaluate the number of days or time a company converts its inventory and other inputs into cash. It considers the days inventory outstanding, days sales outstanding and days payable outstanding for computation. of the business.
- The importance of trade receivable is equally reinforced as most of the analysts while evaluating a business check receivables turnover ratio to understand the working capital management efficiency in collection of payments for credit salesCredit SalesCredit Sales is a transaction type in which the customers/buyers are allowed to pay up for the bought item later on instead of paying at the exact time of purchase. It gives them the required time to collect money & make the payment. undertaken by the business and also to derive bad debts incurred by the business.
#2 – Inventory
- Inventory is another significant part of current assets and, without a doubt, forms an integral component of working capital management. Good Inventory Management is essential since it is responsible for proper control over inventory right from the raw material stage to the finished goods stage.
- Inventory Management begins with inventory control and involves the timely purchase, proper storage, and efficient utilization to maintain even and orderly flow of finished goods to meet timely commitment by the business and at the same time avoid excess working capital in holding of inventory as that will result in a delay in cash conversion cycle and also increase the risk of obsolescence and increase working capital requirement which adversely impacts the profitability of the business.
Inventory can be valued by business in different ways which are enumerated below:
- FIFO InventoryFIFO InventoryUnder the FIFO method of accounting inventory valuation, the goods that are purchased first are the first to be removed from the inventory account. As a result, leftover inventory at books is valued at the most recent price paid for the most recent stock of inventory. As a result, the inventory asset on the balance sheet is recorded at the most recent cost.
- Last in First Out AccountingLast In First Out AccountingLIFO (Last In First Out) is one accounting method for inventory valuation on the balance sheet. LIFO accounting means inventory acquired at last would be used up or sold first.
- Weighted Average Method
The choice of any of the above three methods has an impact on the current assets reported by the business and, consequently, the working capital of the business as inventory. Some of the most popular inventory controlInventory ControlInventory control is adopted by organizations to properly manage the inventory/stock stored in the course of business to minimize storage & carrying charges for the inventory and satisfy its customer’s demands in the market. techniques for effecting working capital management are as follows:
- Min Max Plan
The oldest and conventional method which revolves around determining the maximum and minimum of each stock item be kept following the usage, requirements, and margin of safety to ensure that the business doesn’t lose the risk of stock-out and also to avoid the issue of overstocking as it adversely impacts working capital.
- Order Cycling System
Under this Inventory Management system, quantities of each stock item are reviewed periodically, which is predetermined by the management based on the production cycle and order is placed based on stock level and probable rate of depletion before the next periodic review.
- ABC Analysis
Under ABC analysisABC AnalysisABC analysis refers to the inventory management technique to identify items that constitute a significant part of the overall inventory value and categorize them into critical, essential and moderately important. technique of inventory management, the different stock items are ranked in order of their money value. High-value items are closely attended to, and low-value items are devoted to minimum expenses to ensure proper control of inventories and efficient allocation.
#3 – Cash and Bank Balances
It is said that cash is the king and also an essential component of current asset and cash involves not just cash only but all liquid securities which can be readily converted into cash. Proper Cash Management goes a long way in keeping the working capital cycle in order and also enables the business to manage its operating cycleOperating CycleThe operating cycle of a company, also known as the cash cycle, is an activity ratio that measures the average time required to convert the company's inventories into cash.. Also, business efficiency is determined by the amount of free cash flow to the firmFree Cash Flow To The FirmFCFF (Free cash flow to firm), or unleveled cash flow, is the cash remaining after depreciation, taxes, and other investment costs are paid from the revenue. It represents the amount of cash flow available to all the funding holders – debt holders, stockholders, preferred stockholders or bondholders. (FCFF) it generates. Also, proper utilization of cash ensures business to garner trade discountsTrade DiscountsThe reduction in list price allowed by a supplier to the consumer while selling the product in bulk quantities is referred to as a trade discount. It is carried out in order to boost the sale of the business. and improve the cash conversion cycle, which is a critical yardstick to analyze the working capital cycle of any business.
#4 – Trade Payables
- Trade Payables forms a significant part of current liabilitiesCurrent LiabilitiesCurrent Liabilities are the payables which are likely to settled within twelve months of reporting. They're usually salaries payable, expense payable, short term loans etc.. It also includes the amount due to the bills of exchange payables. These are the amount which the business has to pay for credit purchases made by it. A crafted payables management policy goes a long way in ensuring timely payment and cordial business relations with vendors and creditors.
- Each industry has a specific trade cycle, and businesses must ensure to keep their trade payable cycle in line with the industry. Also, if a business has a shorted trade payable cycle, it will have to keep more cash in hand, resulting in longer trade cash conversion cycles and more interest costs.
- A more extended trade payable period will result in business making payments to their vendors after long periods. However, if the business can keep a short trade receivable period, then such a scenario improves the business cash conversion cycle and resulting in less working capital requirement, which will ultimately boost profits.
- Further, the importance of trade payables is equally reinforced as most of the analysts while evaluating a business check payables turnover ratio to understand the working capital management efficiency and timely payments by the business to honour its obligation to its creditors.
- A high trade payables turnover ratio shows that creditors are being paid promptly by the business and hence enhancing the creditworthiness of the business. However, a very favourable ratio compared to industry practice shows that the business is not taking full advantage of credit facilitiesCredit FacilitiesCredit Facility is a pre-approved bank loan facility to businesses allowing them to borrow the capital amount as & when needed for their long-term/short-term requirements without having to re-apply for a loan each time. allowed by the creditors resulting in more cash requirements.
Working Capital is the lifeline of a business and enables the smooth running of the day to day operations of the business. Each component is essential and plays an indispensable role in ensuring the success and smooth running of the business.
This article has been a guide to What are the Components of Working Capital. Here we discuss the 4 main components of working capital along with a detailed explanation. You may also take a look at our following useful articles –