Understanding the components of working capital and how to manage them effectively is essential to any business. A business’ working capital is its “financial fuel” for the near future.
Components of Working Capital
So what are the components of working capital? First of all, the calculation for working capital is:
Working Capital = Current Assets – Current Liabilities
Current Assets Include:
- Cash and Cash Equivalents
- Accounts Receivable
- Other Short Term Current Assets *
The other short-term current assets have an asterisk because some people prefer to include these accounts, such as prepaid expenses, while others do not. I don’t like including accounts that will not bring in cash. Therefore, excluding prepaid expenses from your current assets is a valid option as long as there is consistency.
For example, suppose a company has low cash, low accounts receivable and high prepaid expenses. In that case, prepaid expenses will distort the working capital balance, while the actual current assets that will bring cash to the company are low. Therefore, there are cases where excluding the prepaid expenses 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 essential 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: A business can increase its cash balance by selling fixed assets. 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.
There are many options a company can pursue to ensure working capital is better managed. Some of these options are covered 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. Impraied stock reduces working captial.
- 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.