Component of Working Capital

Principle & Practice of Management

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Component of Working Capital

Working Capital Components

Efficient management of working capital involves effective control over the current assets and current liabilities, which are the main working capital components.
1. Working Capital Components of Current Assets: Current assets are those assets that in the ordinary course of business, can be or will be turned into cash within an accounting period (not exceeding one year) without undergoing a diminution in value and without disrupting the operations. Total current assets consist of cash, marketable securities, inventories, sundry debtors, one year fixed deposits with banks, and prepaid expenses.
2. Working Capital Components of Current Liabilities: Current liabilities are those liabilities intended to be paid in the ordinary course of business within a reasonable period (normally within a year) out of the current assets or revenue of the business. The current liabilities consist of sundry creditors, loans and advances, bank overdraft, short-term borrowings, taxes and proposed dividend.

Working capital components

Importance of Working Capital

Working capital is considered as a central nervous system of a firm. The importance of working capital management is reflected in the fact that financial managers spend most of their time in managing current assets and current liabilities. Adequate working capital needs to be maintained in order to discharge day-to-day liabilities and protect the business from adverse effects in times of calamities and emergencies. It aims at protecting the purchasing power of assets and maximises the return on investment. In other words, the goal of working capital management is to minimise the cost of working capital while maximising a firm’s profits. Management is required to be vigilant in maintaining appropriate levels in the various working capital accounts. The working capital management is concerned with the determination of relevant levels of current assets and their efficient use as well as the choice of the financing mix. “The efficiency of the firm to earn profits depends largely on its ability to manage working capital. Working capital management has acquired paramount importance in the recent past, especially in view of tight money conditions prevailing in the economy”. Working capital management policies have a crucial effect on
firm’s liquidity and profitability. Thus, working capital plays a crucial role in earning a reasonable rate of return. Hence, working capital has to be effectively planned, systematically controlled and optimally utilized.

Aspects of Working Capital Management

Management of working capital involves the following four aspects:
1. Determining the total funds required to meet the current operations of the firm (i.e., determination the level of current assets);
2. To decide the structure of current assets (i.e., the proportion of long-term and short-term capital to finance current assets);
3. To evolve suitable policies, procedures and reporting systems for controlling the individual components of current assets (Mainly cash, receivables and inventory); and
4. To determine the various sources of working capital.
For determining the sources of working capital (short-term and long-term) capital the net concept becomes useful. However, for determining the level and composition of working capital it is the gross concept, which becomes more meaningful.