Components Of Working Capital Top 4 Detailed Explained

What are the Components of Working Capital?

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.read moreInventoryCash and Bank BalancesTrade Payables

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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.read more 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.read more receivable. These are the amounts in which the business is owned by its customers. A crafted receivables management policy goes a long way in ensuring timely collection and avoiding 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.read more, if any, for the business.Each industry has a specific trade cycle, and businesses must 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.read more of the business.The importance of trade receivables is equally reinforced by most analysts while evaluating a business check receivables turnover ratio to understand the working capital management efficiency in collecting 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. read more 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 from the raw material stage to the finished goods stage.Inventory ManagementInventory ManagementInventory management in business refers to managing order processing, manufacturing, storage, and selling raw materials and finished goods. It ensures the right type of goods reach the right place in the right quantity at the right time and at the right price. Thus, it maintains the product availability at warehouses, retailers, and distributors.read more begins with inventory control and involves the timely purchase, proper storage, and efficient utilization to maintain an 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.read moreLast 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.read moreWeighted Average Method

The choice of any of the above three methods impacts the current assets reported by the business and, consequently, the working capital of the business as inventory. Some of the most popularInventory 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 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. Order is placed based on stock level and probable depletion rate 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 according to their monetary 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 an essential component of current assets, and cash involves not just cash only but all liquid securities that can be readily converted into cash. Proper Cash Management goes a long way in keeping the working capital cycle in order and 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 for analyzing 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.read more. It also includes the amount due to the bills of exchange payables. These are the amounts 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 keep their trade payable cycle in line with the industry. Also, if a business has a shortened 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 make businesses make payments to their vendors after long periods. However, suppose the business can keep a short trade receivable period. In that case, such a scenario improves the business cash conversion cycle and results in less working capital requirement, ultimately boosting profits.Further, the importance of trade payables is equally reinforced by most analysts while evaluating a business check payables turnover ratio to understand the working capital management efficiency and timely payments to honor its obligation to its creditorsA high trade payables turnover ratio shows that creditors are being paid promptly by the business enhancing creditworthinessCreditworthinessCreditworthiness is a measure of judging the loan repayment history of borrowers to ascertain their worth as a debtor who should be extended a future credit or not. For instance, a defaulter’s creditworthiness is not very promising, so the lenders may avoid such a debtor out of the fear of losing their money. Creditworthiness applies to people, sovereign states, securities, and other entities whereby the creditors will analyze your creditworthiness before getting a new loan.read more of the business. However, a very favorable 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. read more 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 business’s day-to-day operations. Each component is essential and plays an indispensable role in ensuring the success and smooth running of the business.

What are the Components of Working Capital?#

4 Main Components of Working Capital#

#1 – Trade Receivables#

#2 – Inventory#

#3 – Cash and Bank Balances#

#4 – Trade Payables#

Conclusion#

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