Components of Working Capital

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Blog Author :

WallStreetMojo Team

Edited by :

Ashish Kumar Srivastav

Reviewed by :

Dheeraj Vaidya, CFA, FRM

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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 comprise trade receivables, inventory, and cash & bank balances, and current liabilities majorly comprise trade payables. The efficient management of these components ensures the profitability of the business and ensures the smooth running of the business.

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How to Calculate Working Capital? Video

 

4 Main Components of Working Capital

  1. Trade Receivables
  2. Inventory
  3. Cash and Bank Balances
  4. Trade Payables
components of working capital

Let us discuss each of them in detail -

#1 - Trade Receivables

  • Trade Receivables form a significant part of the current asset and, therefore, working capital. It also includes the amount due to the bills of exchange 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 debts, 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 cycle 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 sales 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 Management 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:

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 popular inventory control 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 analysis 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 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 a critical yardstick for analyzing the working capital cycle of any business.

#4 - Trade Payables

  • Trade Payables forms a significant part of current liabilities. 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 creditors
  • A high trade payables turnover ratio shows that creditors are being paid promptly by the business enhancing 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 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.