Components of Working Capital
The major component of working capital is current assets and current liability. However, there are many other components under both sections. And we will discuss all of the components in this article.
The working capital is the difference between a company’s current assets and current liabilities. It represents the company’s ability to use the current assets to pay for the current liability. It is the amount that a company keeps without using to invest in the non-current assets.
Current Assets are items that can convert to cash within a short period of time. It also includes cash and cash equivalent as well. They are the assets that a company expects to sell, consume, or used in the normal course of business within one accounting period.
These current assets are important for the business to support its daily operation. The company needs cash to pay for daily expenses and settle for short-term liability. They require to own the inventory to sell for the customers to generate revenue. When they sell on credit, they will generate accounts receivable which is the balance need to be collected from customers.
Current liabilities are the company’s short-term obligations which expect to be paid within a year from the reporting date. These liabilities raise from the company’s normal business operation. They included accounts payable, salary payable, tax payable, and so on.
Working capital measures the company’s ability to use the current assets to settle the current liability.
The stronger working capital represents a healthy financial position. But if it is too high, it shows a loss of investing opportunity.
The lower working capital means that the company has invested its capital for the long-term return. However, it is also risky when they are not able to pay off the current liability on the due date.
Working Capital Formula
Working capital = Current Assets – Current Liabilities
To understand more about working capital, please refer to the explanation of each component in the following section.
Cash and Cash Equivalent
Cash and cash equivalent are the most important current assets on the company balance sheet. The business needs cash to purchase inventory, and fixed assets, pay for employees, and settle with the supplier or other parties. The company cannot operate without cash and cash equivalent.
It is the first line of the current assets on balance sheet. It is the most liquid asset that company can use to pay for purchases or settle with creditors.
Besides actual cash and cash at the bank, it also includes short-term securities which are able to convert into cash straight away. Most of these securities are able to convert into cash in less than three months.
The business requires a sufficient balance of cash to operate with any difficulties. This balance is different depending on the size and nature of the business.
If the company has a high amount of cash on balance sheet, it means that company has a strong financial position. The company has enough ability to pay for the short-term liability. However, too much cash on hand causes the company to lose the opportunity to invest in other investments for a higher return.
Accounts receivable is the amount that company needs to collect from customers who purchase goods or services on credit. The company has sold the goods on credit by allowing customers to have them and make payments later.
The company expects to collect the cash from customs within a short period of time.
We can use the accounts receivable turnover to analyze how strong the company’s ability to collect the cashback after selling on credit. It shows us the estimated percentage of accounts receivable that will be converted to cash.
The accounts receivable and the company’s ability to collect cashback can show the future cash inflow into the company. As we know cash is the most liquidated asset, so these factors will present a strong financial position.
The accounts receivable also allow the owner to sell at a discount to the agency that will collect on behalf of them.
Inventory is the items that company purchase for resell in the trading industry. The company owns inventory with the intention to sell them to customers for profit.
In a manufacturing company, inventory refers to the raw material, working in the process, and the finished goods that are ready to deliver to the customers.
The inventory is classified as the current asset on the company balance sheet. Its value will be different depending on the costing method that the company uses.
The inventory turnover helps us to understand how well the company sells the inventory and receive the cash.
Accounts payable are the current liabilities that represent the amount that the company owes to the suppliers. The company has the obligation to settle these balances within less than a year.
The accounts payable arise from the normal daily business operation such as the purchase on credit.
The company can have accounts payable through the purchase of inventory, fixed assets, and other assets.