It is crucial for a business to understand the components of working capital to be fully able to manage it. Working capital helps a company successfully run its day-to-day operations and face any unforeseen financial needs. Hence, it is important to understand the components of working capital, and the relationship of a business with its current assets and current liabilities. Understanding this relationship helps a business determine how much money it has available to run its operations without any hindrances.
In this blog, we shall discuss the meaning and components of working capital management, and how a business can augment and tap its full potential.
What is working capital?
Working capital is essentially the difference between all the current assets and current liabilities of a business, which form the components of working capital.
All assets that a business has with it in liquid form or can be realised into cash within a fiscal year are current assets. Current liabilities include any liability that a business has to repay within the financial year.
Hence, the formula to calculate working capital is:
|Working Capital = Current Assets – Current Liabilities|
Here is an example to understand it better:
On 27th Sept, 2023, a company called X Manufacturing Ltd, had Rs. 40,000 in cash, Rs. 25,000 worth of raw materials, inventory worth Rs. 50,000 and Rs. 10,000 as trade receivables. It also has trade payables worth Rs. 42,000 and other loans worth Rs. 14,000 to be paid after 2 years. What is the working capital available with X Manufacturing Ltd. on 27th September 2023?
Based on the above formula, let’s first identify the elements of working capital as per the available information.
Current assets = Cash (Rs. 40,000) + Raw Material (Rs. 25,000) + Inventory (Rs. 50,000) + Trade Receivables (Rs. 10,000)
Current Liabilities = Trade Payables (Rs. 42,000)
Note: We will omit the other loans because they are to be paid after 2 years. Current liabilities only include liabilities that are to be repaid within one year.
Hence, the working capital is Rs. 1,25,000 – Rs. 42,000 = Rs. 83,000
In another scenario, if the working capital was negative, it could have forced the company to either halt its operations or avail a working capital loan to make sure there are no hindrances in the operations.
What are the components of working capital?
We have already established that working capital is the difference between the current assets and current liabilities. While they are the umbrella terms for its different components, there are four main components of working capital that you must understand in depth.
- Trade receivables
Also known as account receivables or bills receivables, it forms one of the most significant parts of current assets. It is the due a company owes from its customers in the normal course of business. Examples of trade receivables are promissory notes and bills of exchange.
- Cash and cash equivalent
Cash is the core of any business. By cash, we don’t just mean currency notes or bank balances. It also includes all the assets that can easily be converted into cash at the time of need. Effective cash management can ensure that a company always has enough spare cash to meet any urgent or daily financial needs. Some examples of these securities are money market funds and certificates of deposit.
Another significant element of working capital is inventory. It is the amount of raw materials and finished goods you keep on standby. It is essential for every business to strike a balance between the level of inventory, its usage and its demand. Excessive inventory unnecessarily increases the storage cost, whereas its shortage can lead to a halt in operations and supply of finished goods.
- Trade payables
Just the opposite of trade receivables, trade payables are the dues a business owes to its vendors. When they make credit purchases for their raw materials and other supplies, it is registered as trade payables in the books of accounts. It includes the bills of exchange and promissory notes a business is liable to pay.
Limitations of working capital
Understanding working capital for businesses also means knowing its limitations. While it helps in maintaining the financial health and liquidity of a business, it comes with its own set of drawbacks.
- It is a perpetually changing factor and can vary every day. Depending upon the liabilities you clear and the assets you acquire, it will change. Hence, the working capital calculation made at the beginning of the month may not be the same till the end, and it isn’t feasible to calculate it every day.
- Its calculation only considers working capital components and ignores all other external factors that can affect a company. Recession, inflation, subsidiaries, etc., can also affect the capital availability of a business, which is ignored here.
- It also ignores any sudden devaluation of assets. For example, one of your trade payables can turn into a bad debt. Inventory is susceptible to damage and theft. These factors, while they affect the availability of working capital, are not considered.
How to augment your working capital?
If you are looking for ways to increase your working capital, here are some tips that can help you:
- You can use your business credit card to meet any immediate financial need. However, delaying its repayment can lead to high interest and a depleted credit score.
- Cut down on unnecessary expenses to free up working capital. Through cost-cutting or expense reductions, businesses can increase the value of liquid assets in their business.
- Reduce bad debt to increase the working capital of your business. You can do so by reducing inventory, selling more products that have a higher profitability and implementing better cash management practices.
Unsecured loans, such as Razorpay Line of Credit, are another great alternative to meet your working capital needs. You can easily access cash up to Rs. 25 lakhs at the lowest possible interest rates with a high level of flexibility! Check it out today to meet your working capital requirements.
Q: How to calculate working capital ratio, and what is the ideal ratio?
Ans. The working capital ratio is the ratio between the current assets and current liabilities of a business. It is calculated by dividing the current assets by current liabilities. The ideal ratio is 2:1, which means your current assets should be at least twice your current liabilities.
Q: What are the different components of current assets?
Ans. Different components of current assets include inventory, trade receivables, short-investments and short-term debtors.
Q: What are the different components of current liabilities?
Ans. Current liabilities include wages payable, tax payable, short-term loans, trade payables, and bank overdrafts.