Components of Working Capital

11 Key excerpts on "Components of Working Capital"

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  eBook - PDF

  Financial Accounting Theory and Analysis

  Text and Cases

  • Richard G. Schroeder, Myrtle W. Clark, Jack M. Cathey(Authors)
  • 2019(Publication Date)
  • Wiley

    (Publisher)

  279 8 Working Capital A company’s working capital is the net short-term investment needed to carry on day-to-day activities. The measurement and disclosure of working capital on financial statements have been considered an appropriate accounting function for decades, and so the usefulness of this concept for financial analysis is accepted almost without question. This is not to say that the concept does not present some serious problems, namely (1) inconsistencies in the measurements of the var- ious Components of Working Capital, (2) differences of opinion over what should be included as the elements of working capital, and (3) a lack of precision in the meaning of certain key terms involved in defining the elements of working capital, such as liquidity and current. This chapter examines the foundation of the working capital concept, reviews the concept and its components as currently understood, illustrates how the adequacy of a company’s working capital position can be evaluated, and discusses how the concept might be modified to add to its usefulness. Development of the Working Capital Concept The concept of working capital originated with the distinction between fixed and circulating capital at the beginning of the twentieth century. As noted in Chapter 1, at that time accounting was in its adolescent stage and such concepts as asset, liability, income, and expense were not clearly under- stood. 1 The impetus for the definitions of fixed and circulating capital came from court decisions on the legality of dividends in Great Britain. As first defined, fixed capital was money expended that was sunk once and for all, and circulating capital was defined as items of stock in trade, which are parted with and replaced by similar items in the ordinary course of business. These definitions were not readily accepted by members of the accounting profession, some of whom feared that the general public would misinterpret the distinction.

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  eBook - PDF

  Strategic Managerial Accounting

  Hospitality, Tourism & Events Applications

  • Tracy Jones, Helen Atkinson, Angela Lorenz, Peter Harris(Authors)
  • 2012(Publication Date)
  • Goodfellow Publishers

    (Publisher)

  12 Working Capital Management 12.1 Introduction and objectives Capital is a scarce resource in any business and enormous attention is given to ensuring the right sources of finance are found and properly utilised with respect to the long-term non-current asset requirements of an organisation. However any business will require capital for short-term needs as well as long-term and this is known as working capital. After studying this chapter you should be able to: „ Understand the importance of working capital to the business „ Evaluate the different working capital policies that can be adopted by a firm „ Understand what the key Components of Working Capital are „ Consider the working capital requirements of a firm with respect to inventory, accounts receivable, cash and accounts payable „ Establish sound policies for the efficient management and control of the key component elements. 12.2 Understanding working capital In the short term a business needs to ensure that it can pay its expenditure from its income, to generate income it must sell its products or services to custom-ers. In doing this the business will often buy inventory – goods to sell on as a retailer, or raw materials with which to make a finished product such as a meal in a restaurant. The inventory then has to be sold to a customer (at a profit) and when the customer pays, cash flows back in to the business (Figure 12.1). The organisation must ensure it has enough capital invested to ensure that it can buy the required inventory and still pay bills while it waits for the inventory to be sold and the customers to pay. This in essence is the working capital requirement of the business. 194 Strategic Managerial Accounting Cash from customers Buy inventory Produce products/services Sell products/ services Customers owe money Figure 12.1: The trade cycle The working capital of a business can be easily measured by looking at its statement of financial position.

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  eBook - PDF

  Financial Accounting Theory and Analysis

  Text and Cases

  • Richard G. Schroeder, Myrtle W. Clark, Jack M. Cathey(Authors)
  • 2022(Publication Date)
  • Wiley

    (Publisher)

  293 8 A company’s working capital is the net short-term investment needed to carry on day-to-day activities. The measurement and disclosure of working capital on financial statements have been considered an appropriate accounting function for decades, and so the usefulness of this concept for financial analysis is accepted almost without question. This is not to say that the concept does not present some serious problems, namely (1) inconsistencies in the measurements of the var- ious Components of Working Capital, (2) differences of opinion over what should be included as the elements of working capital, and (3) a lack of precision in the meaning of certain key terms involved in defining the elements of working capital, such as liquidity and current. This chapter examines the foundation of the working capital concept, reviews the concept and its components as currently understood, illustrates how the adequacy of a company’s working capital position can be evaluated, and discusses how the concept might be modified to add to its usefulness. Development of the Working Capital Concept The concept of working capital originated with the distinction between fixed and circulating capital at the beginning of the twentieth century. As noted in Chapter 1, at that time accounting was in its adolescent stage and such concepts as asset, liability, income, and expense were not clearly understood. 1 The impetus for the definitions of fixed and circulating capital came from court decisions on the legality of dividends in Great Britain. As first defined, fixed capital was money expended that was sunk once and for all, and circulating capital was defined as items of stock in trade, which are parted with and replaced by similar items in the ordinary course of business. These definitions were not readily accepted by members of the accounting profession, some of whom feared that the general public would misinterpret the distinction.

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  eBook - PDF

  Financial Accounting Theory and Analysis

  Text and Cases

  • Richard G. Schroeder, Myrtle W. Clark, Jack M. Cathey(Authors)
  • 2020(Publication Date)
  • Wiley

    (Publisher)

  248 CHAPTER 8 A company’s working capital is the net short‐term investment needed to carry on day‐to‐day activities. The measurement and disclosure of working capital on financial statements has been considered an appropriate accounting function for decades, and so the usefulness of this con- cept for financial analysis is accepted almost without question. This is not to say that the concept does not present some serious problems, namely (1) inconsistencies in the measurements of the various Components of Working Capital, (2) differences of opinion over what should be included as the elements of working capital, and (3) a lack of precision in the meaning of certain key terms involved in defining the elements of working capital, such as liquidity and current. This chapter examines the foundation of the working capital concept, reviews the concept and its components as currently understood, illustrates how the adequacy of a company’s working capital position can be evaluated, and discusses how the concept might be modified to add to its usefulness. The concept of working capital originated with the distinction between fixed and circulating capital at the beginning of the twentieth century. As noted in Chapter 1, at that time accounting was in its adolescent stage and such concepts as asset, liability, income, and expense were not clearly understood. 1 The impetus for the definitions of fixed and circulating capital came from court decisions on the legality of dividends in Great Britain. As first defined, fixed capital was money expended that was sunk once and for all, and circulating capital was defined as items of stock in trade, which are parted with and replaced by similar items in the ordinary course of business. These definitions were not readily accepted by members of the accounting profession, some of whom feared that the general public would misinterpret the distinction.

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  eBook - ePub

  The Strategic Treasurer

  A Partnership for Corporate Growth

  • Craig A. Jeffery(Author)
  • 2009(Publication Date)
  • Wiley

    (Publisher)

  CHAPTER 7

  Owning Working Capital

  Working capital is not just ratios and balances on paper. It exists out in the operations of the company. By going out to the local divisions and watching how the receivables, payables and other areas function, you will truly understand the working capital of your business, how it works and how it can be optimized.

  —Arthur P. Lorenz, Treasurer & Director of Financial Planning & Analysis, HunterDouglas          

  The Treasurer is often the rightful owner of working capital and must, therefore, manage it appropriately. To accomplish this goal, there are some new methods and techniques that are gaining traction with Treasurers. The value of optimizing most organizations’ working capital is well recognized. And every well-run organization manages working capital in a thoughtful and active manner.

  The following will identify and distinguish two common definitions of working capital and their differing purposes. The two methods will be explained. Appropriate and different uses will be discussed, and the impact of distinctions between liquidity measures and historical working capital-related items will be highlighted. Several considerations will be explored along the lines of projecting working capital usage and, finally, several areas of recommendations will be presented to assist those who are charged with managing working capital.

  Two Definitions of Working Capital

  The term working capital refers to a formula. Since there are two primary definitions of working capital—accounting and treasury—it is instructive to know which one is being referred to in order to understand the context.

  Working Capital: Accounting Definition (Traditional)

  The first definition may be referred to as the “accounting definition of working capital.” This definition is also known by many to be the traditional formula for working capital. The definition, shown as a formula, is:

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  eBook - PDF

  Corporate Finance

  Theory and Practice in Emerging Economies

  • Sunil Mahajan(Author)
  • 2020(Publication Date)
  • Cambridge University Press

    (Publisher)

  Short-term assets comprise investments in inventory, debtors (accounts receivables) and creditors (accounts payable). Usually in finance, the distinction between the long-term and the short-term period is taken as one year. Accounts receivables, payables and the inventory cycle generally last for less than one year and are, therefore, considered to be short-term investments. Concept of Working Capital Working capital comprises the following: 1. Accounts payable: Corporates are in the business of producing and selling goods and services. The raw material is ordered for production for which suppliers need to be paid. Companies are usually able to get credit on supplies and can defer payments to a later date. The amount of payment, due to the suppliers at any point in time, is termed accounts payable/creditors. The accounts payable reduces the requirement of working capital for the company. 2. Raw material inventory: All raw material purchased may not be consumed immediately; part of it is stocked as inventory to be utilized as and when required. For instance, components required for the production of a laptop are ordered in bulk and then used as per the production schedule. Similarly, Raymond Ltd may order raw wool from Australia in bulk and use it over a period of time for its range of woollen suits. Product and industry characteristics, along with supply chain conditions, determine the inventory level of raw material that needs to be maintained. The raw material may also include spares and replacement parts. 3. Work in process: The raw material becomes work in process once production starts until the final product is ready. During the period of production, the company carries an inventory of work in process. Longer the production cycle, higher is the level of work in process. 4. Finished goods inventory: Even after the final goods have been produced, the sale may not take place immediately. Companies thus carry the inventory of final goods until these are sold.

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  eBook - PDF

  Contemporary Financial Management

  • R. Charles Moyer, James McGuigan, Ramesh Rao, , R. Charles Moyer, James McGuigan, Ramesh Rao(Authors)
  • 2017(Publication Date)
  • Cengage Learning EMEA

    (Publisher)

  Working capital is used by firms to maintain liquidity, that is, the ability to meet their cash obligations as they come due. Otherwise, it may incur the costs associated with a deteriorating credit rating, a potential forced liquidation of assets, and possible bankruptcy. Working capital management is a continuing process that involves a number of day- to-day operations and decisions that determine the following: The firm’s level of current assets The proportions of short-term and long-term debt the firm will use to finance its assets The level of investment in each type of current asset The specific sources and mix of short-term credit (current liabilities) the firm should employ Working capital differs from fixed capital in terms of the time required to recover the investment in a given asset. In the case of fixed capital or long-term assets (such as land, buildings, and equipment), a company usually needs several years or more to recover the initial investment. In contrast, working capital is turned over, or circulated, at a relatively rapid rate. Investments in inventories and accounts receivable are usually recovered dur- ing a firm’s normal operating cycle, when inventories are sold and receivables are collected. 16-2a Importance of Working Capital It has already been noted that a firm must have working capital to operate and survive. In many industries, working capital (current assets) constitutes a relatively large percentage of total assets. In the manufacturing sector, for example, current assets comprise about 40 percent of the total assets of all U.S. manufacturing corporations. Table 16.1 shows the distribution of aggregate assets for several large companies. For the five companies shown, current assets as a percentage of total assets range from about 15 percent to over 42 percent. ExxonMobil, with its relatively high percentage of fixed assets, has a relatively low percentage of current assets.

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  Corporate Finance

  Economic Foundations and Financial Modeling

  • Michelle R. Clayman, Martin S. Fridson, George H. Troughton, Michelle R. Clayman, Martin S. Fridson, George H. Troughton(Authors)
  • 2022(Publication Date)
  • Wiley

    (Publisher)

  3. WORKING CAPITAL, LIQUIDITY, AND SHORT-TERM FUNDING NEEDS Companies require sufficient resources to meet day-to-day obligations—such as paying suppliers and employees as well as meeting lease terms and other financial commitments— and to continue operations as a going concern. Successful companies seek to balance funds dedicated to current assets (most of which earn minimal returns or even decline in value as inventory becomes increasingly obsolete) against the risk of shortages in current assets negatively impacting day-to-day operations, while keeping focus on longer-term goals. Working capital requirements are often a function of a firm’s particular business model. Some businesses require heavy investment in inventory and receivables, while others do not. Retail businesses—particularly those with physical (“brick and mortar”) locations or significant inventory and those operating more heavily on credit (vs. cash)—require substantially more working capital to fund their day-to-day operations. In contrast, technology businesses—such as software companies or online-only businesses with large amounts of intangible assets and few physical assets—have far lower working capital needs. There are wide variations, however, in working capital needs even among firms in the same industry or segment. Companies typically determine their required working capital investment by first identifying their optimal levels of inventory, receivables, and payables, as function of sales, and then modeling those assumptions forward for the business. In establishing what is “optimal,” a company’s management usually evaluates some trade-off between costs, both the cost of capital for the company and obsolescence risks with its inventory, and benefits, such as fewer inventory shortfalls (or stockouts) and more accommodative credit policies, which management believes will translate to higher sales or revenues.

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  eBook - PDF

  HRM in Agri-Business

  • Thumar, V M(Authors)
  • 2018(Publication Date)
  • Daya Publishing House

    (Publisher)

  Unit 8: Working Capital Management in Agri-business 8.1 Introduction Working capital is significant in financial management due to the fact that it plays an important role in keeping the wheels of a agri-business enterprise running. It may be regarded as lifeblood of a agri-business. It is concerned with short term financial decisions. Its effective provision can do much to ensure the success of a agri-business, while its inefficient management can lead not only to loss of profits but also to the ultimate downfall of promising concept. A study of working capital is of major importance to internal and external analysis because of its close relationship with day-to-day operations of a agri-business. Working capital management includes management of various components of current assets as well as current liabilities. A firm invests a part of its permanent capital in fixed assets and keeps a part of it for working capital i.e. for meeting the day to day requirements. The requirements of working capital varies from firm to firm depending upon the nature of agri-business, production policy, market conditions, seasonality of operations, conditions of supply etc. Working capital management if carried out effectively, efficiently and consistently will assure the health of an organization. 8.2 Meaning and Definition In accounting, W. C. is the difference between the inflow and outflow of funds. It is the net cash inflow. This ebook is exclusively for this university only. Cannot be resold/distributed. W.C. is defined as the excess of current assets over its current liabilities and provision. Current assets are those assets which will be converted into cash with the current account period or within the next year as a result of the ordinary operations of the agri-business.

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  Fundamentals of Corporate Finance

  • Robert Parrino, David S. Kidwell, Thomas Bates(Authors)
  • 2016(Publication Date)
  • Wiley

    (Publisher)

  When they finance seasonal working capital requirements for inventories and receivables, most financial managers also prefer to match maturities of assets and liabilities by financing these investments with short-term debt. As a firm’s sales rise and fall seasonally, a financial manager can expand or contract working capital by borrowing short-term when more assets are needed and, as cash becomes available, using it to pay off the short-term obligations as they mature. Permanent Working Capital Many financial managers prefer to fund permanent working capital with long-term funds, as shown in Figure A in Exhibit 14.7. They prefer to do this in order to limit the risks associated with a short-term financing strategy. To the extent that permanent working capital is financed with long-term funds, the ability of the firm to finance this minimum level of working capital is not subject to short-term credit market conditions. As illustrated in Figure C of Exhibit 14.7, other managers use short-term debt to finance at least some permanent working capital requirements. These managers subject their firms to more risk in the hope that they will realise higher returns. Sources of Short-Term Financing Now that we have discussed working capital financing strategies, we will turn our attention to the most important types of short-term financing instruments used in practice: accounts payable, bank loans and commercial paper. Accounts Payable (Trade Credit) Accounts payable (trade credit) deserves special attention because it comprises a large portion of the current liabilities of many businesses. For example, accounts payable constitute about 35 per cent of total current liabilities at publicly traded manufacturing firms. Accounts payable arise, of course, when managers do not pay for purchases with cash on delivery but instead carry the amount owed as an account payable.

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  Fundamentals of Corporate Finance

  • Robert Parrino, David S. Kidwell, Thomas Bates, Stuart L. Gillan(Authors)
  • 2021(Publication Date)
  • Wiley

    (Publisher)

  We next explore the main strategies used by financial managers to finance working capital, along with their benefits and costs. Strategies for Financing Working Capital In order to fully understand the strategies that might be used to finance working capital, it is important to recognize that some working capital needs are short term in nature and that others are long term, or permanent. As suggested earlier, the amount of working capital at a firm tends to fluctuate over time as its sales rise and fall with the business season. For exam- ple, a toy company might build up finished goods inventories in the spring and summer as it prepares to ship its products to retailers in the early fall for the holiday season. Working capital for the company will remain high through the fall as finished goods inventories are sold and converted into accounts receivable but will then decline in January as receivables are col- lected—at which point the seasonal pattern begins again. These fluctuations reflect seasonal working capital needs. Even during the slowest part of the year, the typical firm will hold some inventory, have some outstanding accounts receivable, and have some cash and prepaid expenses. This minimum level of working capital can be viewed as permanent working capital in the sense that it reflects a level of working capital that will always be on the firm’s books. Exhibit 14.7 shows three basic strategies that a firm can follow to finance its working capital and fixed assets. The wavy line in each figure indicates the total financing needed for (1) seasonal working capital needs and (2) permanent working capital and fixed assets. The wavy line is upward sloping because we are assuming that the business represented in the figures is a going concern that is growing over time. As businesses grow, they need more working capital as well as more long-term productive assets. We next discuss each of the three strategies illustrated in the exhibit.

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