Components of Working Capital

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

  1. 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.read more
  2. Inventory
  3. Cash and Bank Balances
  4. Trade Payables
Components-of-Working-Capital

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Let us discuss each of them in detail –

#1 – Trade Receivables

#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:

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.read more 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.read more 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.read more. 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.read more (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.read more and improve the cash conversion cycle, which is a critical yardstick to analyze the working capital cycle of any business.

#4 – Trade Payables

Conclusion

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.

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