4 Components Of Working Capital Loan Explained

4 Components Of Working Capital Loan Explained

Introduction

Economic development has seen an upsurge in recent times due to the better and innovative means of business available. Government policies and cooperation have also paved the way for more and more entrepreneurs to set up their dream businesses. For a business to start-up and thrive, it requires sufficient funding at all steps. Other than the minimum investments for assets and inventory, it also requires an appropriate amount of Working Capital. This is the cash or the funds that the organisations need to manage their operations regularly.

Need for Working Capital Management

Effective management of Working Capital is necessary for maintaining efficient cash flow in the organisation. Every organisation has its current assets in the form of its stock, debtors and prepaid expenses that can be converted to cash within a year. Similarly, a company also has short term liabilities in the form of its creditors, outstanding expenses and rents. A healthy balance should be established between these two levels to ensure overall positive liquidity for the firm. Here are some of the purposes that Working Capital Management serves:

  • To ensure a balance between a company's growth and profitability
  • Payment of short term liabilities and debts
  • Taking care of the day to day expenses of the company
  • Proper management of the company’s current assets and current liabilities

Components of Working Capital

Working Capital for an organisation has to be effectively managed so that all current assets and liabilities of the firm can be used efficiently and optimally to reduce the total cost of business. A company's cash flow is determined by the amount of money coming in, money going out and its inventory.

Thus, components of Working Capital can be classified as:

  1. Cash
  2. Accounts Receivable (Debtors)
  3. Accounts Payable (Creditors)
  4. Inventory/Stock

Let us explore these components one by one.

1. Cash

Cash is the most important form of liquid assets to be possessed by a company. Cash can be Ready Cash in the form of notes, coins, and bank balance or it can be Near Cash in the form of marketable securities and treasury bills that can be converted to cash shortly.  

Cash is always needed by a company to manage its routine operations or to meet unexpected expenses. Hence a healthy flow of cash has to be constantly maintained in the company.

Cash management is valuable in maintaining a company’s liquidity and credit rating. It maintains a balance between short term investments and cash payouts. Companies may employ Fund Managers for maintaining an adequate cash balance in the organisation.

2. Accounts Receivable 

Accounts receivable comprises of the Debtors of the company from which profits or payments are due. This can be due to the sale of goods or services rendered by the business to them. A timely collection of payments from these debtors is necessary to maintain cash flow in the organisation.

Accounts Receivables can be converted into assets only when they are collected and materialized.

The amount of account Receivable of a company depends on the following

  • Credit sale-Establishing appropriate credit limits for the customers and sticking to them
  • Debt Collection-Collection of payments on time

Accounts Receivable Management

  • Evaluating the client's creditworthiness and risk involved
  • Establishing proper terms of sales and credit
  • Adopting an appropriate receivable collection process
  • Proper handling of delinquent accounts

3. Accounts Payable

Accounts Payable consists of the creditors of the company or those from whom the company purchases goods on credit. This is the amount that the company has to pay in the short term. It is just like a set of unpaid bills. It may occur because of any of the following reasons

a. Purchase of Inventory

b. Any new purchases

It has to be kept in mind that purchases cause cash outflows and the purchasing function should not result in creating liquidity problems for the company. It appears as a current liability for the company. It has to be paid at the earliest to avoid default.

 Payments should be balanced in such a way to maintain the credit rating of the company and at the same time, maintain harmonious relationships with the suppliers or the creditors.

Account Payable Management

  • Payments should be made on time for suppliers to avail of any discounts or rebates.
  • Delaying payments for a long time may maintain free cash in the business but will reduce supplier goodwill and response.
  • Adopting appropriate methods for the customer to business payments through e-commerce
  • Short term finance or trade credit should be encouraged, wherever required

4. Stock or Inventory

Stock or inventory is an important component of working capital. An increase in inventory results in an increase in the working capital. Inventory can be in the form of raw material, any work in progress and finished goods. For retail companies like those into grocery sales or clothing, inventory may include up to 70% of the working capital.

Inventory management results in a lot of opportunity costs for the management in the form of insurance, storage, and tracking. High levels of inventory may result in high opportunity costs and poor utilization of working capital. Low levels of inventory may harm customer relations and reduce revenue.

A proper balance has to be established in Inventory Management.

Inventory Management

  • Use FIFO-First In, First Out wherever possible.
  • Efficient contingency planning methods to be adopted
  • Set par levels for each item of inventory.
  • Avoid spoilage and dead-stock
  • Regular auditing of products and spot checking

Conclusion

Working Capital is a comprehensive concept and a lot more than just managing the cash inflow and outflow. A healthy flow of working capital should always be maintained in business to aim for profitability and at the same time, maintaining your assets, customers, and investments.

Last updated:11/16/2019 2:12:40 AM
Ketan Choudhari

Ketan Choudhari

I'm a Digital Marketer with 10 years of experience into SEO & SEM. I have worked on SEO and Content Optimization for many brands across various categories, Like Business, Health, Travel, Real Estate, Ecommerce, etc.

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