Being able to understand what the components of working capital are and how to effectively manage them is very important for a business owner, for a senior executive and for an accountant. Working Capital can be used to understand the financial position of a company and be able to assess whether there is enough “financial fuel” for the near future.
Components of Working Capital
So what are the components of working capital. First of all, working capital can be calculated as:
Working Capital = Current Assets – Current Liabilities
Current Assets Include:
- Cash and Cash Equivalents
- Accounts Receivable
- Other Short Term Current Assets *
The reason that the other short term current assets have an asterisk is that there are people who prefer to include accounts such as prepaid expenses and other people who prefer not to include them. I personally don’t like including accounts that will not bring cash (there is no cash inflow). Therefore, excluding prepaid expenses from your current assets is a valid option as long as there is consistency.
For example, if a company has low cash, low accounts receivable and high prepaid expenses, the working capital will be distorted by the prepaid expenses while the actual current assets that will bring cash to the company can be low. Therefore, there are cases where excluding the prepaid expenses or other accounts that are not readily translated into cash is a valid option.
Similarly, current liabilities include accounts payable, short term accruals, taxes payable, dividends payable and other short term liabilities that will cause a cash outflow in the short term.
Sources of Working Capital
Apart from the components of working capital, it’s also important to understand the sources of working capital. Working Capital can be generated by :
- Sales: Revenue generated increases cash and accounts receivable and therefore increases the working capital.
- Sale of fixed assets: By selling fixed assets that are not being used, a company can increase it’s cash balance. In addition, companies can have the option to sell their fixed assets and lease them back from leasing companies.
- Share Capital Injection: The owners of a company can inject capital in the company increasing the cash and the share equity accounts, therefore increase the working capital.
- Bank Loans: A company can choose to raise long term debt to finance both short term and long term liabilities. If the loan is short term, then the net effect in the working capital will be nil since there will be an increase in cash and an equal but opposite increase in the current liabilities.
Managing the components of working capital
There is more than thing that a company can do to manage the working capital. Some of these points are already mentioned above but other options include:
- Negotiate discounts with your suppliers: People usually think that paying your suppliers on time can be a bad thing. However, having good relationships with your suppliers is vital since you can negotiate credit terms, achieve better prices or achieve discounts for bulk orders. Therefore, managing to reduce the accounts payable increases the working capital.
- Manage your inventory to avoid having obsolete stock: It’s not the easiest task especially for big companies that operate in industries such as technology, fashion etc. However, having high stock levels costs and it’s risky. It’s therefore important to be able to forecast the demand and manage your stock levels accordingly. Impaired stock means that the working capital is reduced.
- Alternative Financing: Companies also have the option to effectively discount their long term assets such as accounts receivable by using factors (invoice factoring). Decreasing your long term assets and increase your short term assets directly increases the working capital.