Effective management out of working capital is actually essential for the profitability as well as maintaining financial stability of any business. For efficient management you should know the various aspects of working capital management as well as different components of working capital management. Working capital is the funds, which is used to run, perform and conduct business activities.
Mostly investors and analyst assess for components of working capital to evaluate company’s cash flow as their keys elements. For example: how funds are received, how funds are paid, how well inventory is managed, etc. Such analysis assure whether business constantly keeps sufficient money to meet with their short-term operating expenses and short-term debt commitments.
Aspects of Working Capital Management
There are broadly two components of working capital management or you can say two aspects of working capital management. They are as mentioned below:
Current assets are those assets which can be easy convertible to cash within one-year. So that current assets can be utilized to meet necessary day- to-day operations for a business. Managing current assets is the primary objective for effective working capital management.
The current assets have always been cash or close to cash means. For example: Short-term advances, Cash and bank balances, Receivables, Prepaid expenses, Temporary investments, Inventory of finished goods, Inventory of raw materials, Inventory of work-in-progress, etc.
Current liabilities are claims from external parties which are expected to be payable within one year of accounting period. For example: Creditors for goods purchased, Short-term borrowings, Taxes and dividends payable, Outstanding expenses, Advances received against sales, Other liabilities maturing within a year.
Components of Working Capital Management
They are several main components of working capital management. For example: cash, inventory, accounts receivable, trade credits, marketable securities, loans, Insurances etc. Let us understand some of them below:
Cash / Money
Cash is the most liquid form of funds, hence it is one of the huge important components of working capital. It is necessary for every business to maintain optimum level of cash in hand regardless if other existing assets is substantial.
Cash act as an effective instrument at various stages of product life cycle. Cash in hand plays an important role to balance any gaps arising between productions to distribution cycle.
Accounts receivable tend to be profits due which is owed to a business by their clients for the sale of goods. Efficient, timely collection of account receivable is most essential to maintain financial health of the company’s operation.
For example: marketable securities consist of commercial papers offered by companies, acceptance letter, treasury bill, etc. These instruments can be bought and sold at quicker and reasonable rate. They usually have less than one year as their maturity period. This attract company’s to investment additional cash reserves and also can be used as highly liquid assets.
Accounts receivable have always been under assets side of a company’s balance sheet, but they are not actually assets until these are typically collected. A commonly used method by analysts to evaluate the organization’s accounts receivable cycle is that, day’s sales outstanding, that reveals that the typical average days an organization sales cycle to collect profits from sale of goods.
Account payable, the money an organization need to pay out throughout the short term, is also an another key components of working capital management. Normally company’s effectively maintain balance between maximum cash flow simply by delaying payments as long as it is fairly potential. In addition, they need to keep positive credit ranks / scores while dealing with creditors as well as suppliers. Commonly, a business’s average time for account receivables are significantly shorter than the average time for account payable’s.
Stock / Inventory
Stock is one of the main components of working capital. An organization’s main asset that it transforms in to sales profits and earnings. The speed at which business sells and restock is significant to determine its success. Stock are of various types, which includes stock as raw material, stock as work in progress or stock in finished goods.
Investors give consideration to their stock turnover level become a sign of this strength to sales and as a measure towards how efficient the business looks in their buying as well as production process. Stock that is minimal, puts the company into danger zone of getting rid of off product sales. Again excessively high stock levels express inefficient utilization of working capital.
Here we have understood some of the important components of working capital management as well as significant aspects of working capital management one should consider. It is very important to maintain those ratios to play a win-win business game. These ratios are the heart of any company where investors, analyst or shareholders rely upon. Hope this was useful for you. Leave your feedback to help us serve better to our readers.
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Basics of Working Capital Management for Beginners
- Chapter 1: What is Working Capital Management?
- Chapter 2: Importance of Working Capital Management
- Chapter 3: Objectives of Working Capital Management
- Chapter 4: Types of Working Capital
- Currently Reading: Components of Working Capital Management
- Chapter 6: Working Capital Cycle
- Chapter 7: Working Capital Finance
- Chapter 8: Net Working Capital
- Chapter 9: Working Capital Requirement
- Chapter 10: Working Capital Management Quiz For Beginners
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