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 Receivables
- Inventory
- Cash and Bank Balances
- Trade Payables
Let us discuss each of them in detail –
#1 – Trade Receivables
- Trade Receivables form a major part of the current asset and therefore, working capital. It also includes the amount due to the bills of exchange 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 debts if any for the business.
- Each industry has a specific trade cycle and businesses must ensure to keep its trade receivable cycle in line with the industry. A longer trade receivable period will result in a delayed collection of cash impacting the cash conversion cycle 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 sales undertaken by the business and also to derive bad debts incurred by the business.
#2 – Inventory
- Inventory is another major part of current assets and without 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 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 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:
- First in First Out (FIFO)
- Last in First Out (LIFO)
- 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 control techniques for effecting working capital management are as follows:
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Min Max Plan
The oldest and conventional method which revolves around determining 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.
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Order Cycling System
Under this Inventory Management system, quantities of each stock item are reviewed periodically which is predetermined by the management based on production cycle and order is placed based on stock level and probable rate of depletion before the next periodic review.
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ABC Analysis
Under this technique of inventory management, the different stock items are ranked in order of their money value and high-value items are closely attended and low-value items are devoted 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 important 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 cycle. Also, business efficiency is determined by the amount of free cash flow to the firm (FCFF) it generates. Also, proper utilization of cash ensures business to garner trade discounts and improve the cash conversion cycle which is an important yardstick to analyze the working capital cycle of any business.
#4 – Trade Payables
- Trade Payables forms a major part of current liabilities. 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 its trade payable cycle in line with the industry. Also if a business is having a shorted trade payable cycle it will have to keep more cash in hand resulting in longer trade cash conversion cycles and more interest cost.
- A longer trade payable period will result in business making payment to its 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 honor 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 favorable ratio compared to industry practice shows that the business is not taking full advantage of credit facilities allowed by the creditors resulting in more cash requirements.
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 important and plays an indispensable role in ensuring the success and smooth running of the business.
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