Working Capital Management: Components of Working Capital | Commerce & Accountancy Optional Notes for UPSC PDF Download

Working capital comprises two key elements: current assets and current liabilities. Current assets encompass various items, including:

• Cash reserves to cover expenses as they arise.
• Accounts receivables or sundry trade debtors.
• Inventory consisting of:
  • Raw materials, stores, supplies, and spares.
  • Work-in-process.
  • Finished goods.

Additionally, current assets may include:

• Advance payments for expenses or purchases, along with other short-term recoverable advances.
• Temporary investments of surplus funds that can be readily converted into cash when required.

Part of the financing for current assets may be sourced from the supply of goods on credit or the deferment of payment for expenses as per custom, usage, or arrangements. The remaining funding requirements for working capital may be fulfilled through short-term borrowing from entities such as banks. These collectively constitute current liabilities, which typically include:

• Goods purchased on credit.
• Business expenses (e.g., wages or salaries, rent, electricity bills, interest, etc.) that are yet to be settled.
• Temporary or short-term borrowings from banks, financial institutions, or other parties.
• Advances received from parties against goods to be sold or delivered, or as short-term deposits.
• Other current liabilities such as taxes and payable dividends.

This overview highlights some of the primary components of current assets.

• Cash: Cash serves as the fundamental resource necessary to initiate any business venture. Initially, it's essential for acquiring fixed assets such as plants and machinery, enabling production and eventual cash generation through sales. Moreover, cash is allocated to working capital investments, crucial for storing raw materials and finished goods, as well as extending credit terms to customers.
  • Maintaining a minimum cash balance facilitates routine business operations like purchases, sales, and handling unforeseen expenses or contingencies. Cash invested at the start of the operating cycle is typically replenished by its conclusion to fund new investments. However, additional cash injections are necessary when acquiring more fixed assets, scaling operations, or adjusting the working capital cycle, such as extending credit to customers.
  • The demand for cash is influenced by various factors, some under managerial control and others external. Operating without holding cash is impractical, yet holding excess cash without purpose incurs direct costs like interest or loss of potential income.
  • In the realm of working capital management, cash management entails optimizing the benefits and costs associated with cash holdings. This objective is best achieved by accelerating the working capital cycle, particularly the collection process, and investing surplus cash in short-term assets yielding optimal returns. Subsequent discussions will delve into topics such as cash flow management and determining the optimal cash balance.
• Accounts Receivable: While firms ideally prefer cash sales, competitive pressures often necessitate offering credit. This widespread use of credit in transactions leads to accounts receivable. Granting credit to consumers prompts businesses to seek credit from their suppliers, termed trade credit. Despite commercial bank support for working capital, trade credit remains a significant funding source, with resulting accounts receivable constituting a major investment for firms.
  • Managing accounts receivable involves balancing direct and indirect costs while leveraging its benefit of boosting sales. Excessive receivables can hinder cash flows and increase bad debts, potentially reducing firm profits. Thus, vigilant and regular receivables monitoring and management are essential, a topic to be explored further in MS-41: Working Capital Management.
• Inventory: When envisioning a manufacturing unit, the essential components include machines, labor, and materials. Efficient management of these elements is pivotal for a business's success, with inventory being a critical asset alongside other current assets.
  • Inventory constitutes a significant portion of working capital in manufacturing organizations, necessitating careful control to optimize costs and maximize benefits. Inventory management encompasses physical and value control to ensure efficient costing, as inventories often represent over 60% of current assets.
  • While holding inventory offers various benefits like facilitating production, ensuring price stability, and enabling prompt customer delivery, excessive inventory incurs significant costs. These costs include the opportunity cost of tied-up funds, storage expenses, and costs associated with stockouts. Therefore, the level of inventory should justify the benefits, considering factors like industry nature, material availability, and technological advancements.
• Marketable Securities: Although cash and marketable securities are often grouped together in current asset analysis, they differ in liquidity. While not as readily convertible as cash, marketable securities can be swiftly converted into cash when needed. Holding excess cash beyond immediate requirements results in missed income opportunities, hence surplus cash is commonly invested in marketable securities. These investments serve the dual purpose of providing liquidity and earning returns.