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COMPONENTS OF WORKING CAPITAL

Cash
Cash is probably the least productive asset you can have. Not only does it not earn anything, it actually loses
purchasing power as a consequence of inflation. So why do firms hold cash? The three Keynsian motives for
holding cash balances are
Transactions motive to conduct day-to-day business of paying for purchases, labor, etc.
Precautionary motive to cover unexpected expenditures. If the delivery truck breaks down, it must
be repaired or replaced if you want to stay in business.
Speculative motive unusually good opportunities occasionally arise. If you have the money
available, you can take advantage of these opportunities.
While cash is necessary to cover the transactions motive, the precautionary and speculative motives can be covered
with the near money (or near cash) of marketable securities.
In order to maximize your cash balances, you can do one of two things; either accelerate the inflow of funds (ask
for an advance on your salary) or delay the outflow of funds (postpone paying the phone bill until next month). But
why would we want to maximize our cash holdings if it is the least productive asset? Because idle cash, either
sitting in a checking account or tied-up in accounts receivable is extremely costly.
Accounts Receivable
Accounts receivable are generated when a firm offers credit to its customers. The first thing that needs to be
addressed when establishing a credit policy is to set the standards by which a firm is judged in determining whether
or not credit will be extended. There is whats known as the 5 Cs of credit:
1. Character the willingness of the borrower to repay the obligation
2. Capacity the capability of the borrower to earn the money to repay the obligation
3. Capital sufficient assets available to support operations (as opposed to a firm that is
undercapitalized). Sometimes capital is interpreted to mean equity capital; i.e., to make sure the owners
of the firm have sufficient money at stake to give them proper incentive to repay the loan and not let the
company go bankrupt.
4. Collateral assets to support the loan which can be liquidated if default occurs
5. Conditions current and future anticipated conditions of the firm and the industry.
Inventories
Inventories (raw materials, work-in-process, finished goods) make up a large portion of most firms current
assets, and for many, total assets. As such, the extent to which a firm efficiently manages its inventories can have a
large influence on its profitability. Thus, keeping abreast of inventory policy is critical to the profitability (and
value) of the firm.
COMPONENTS OF WORKING CAPITAL
You have already noted that working capital has two com ponents: Current assets and
Current liabilities. Current assets comp rise several item s. The typical item s are:
i) Cash to meet expenses as and when they occur.

ii) Accounts Receivables or sundry trade debtors

iii) Inventory of:
Raw m aterials, stores, supplies and spares,
Work-in-process, a n d
Finished goods
Advance payments towards expenses or purchases, and other short-term ad-vances which are recoverable.
Temporary investment of surplus funds which could be converted into cash whenever needed.
A part of the need for funds to finance the current assets may be met from supply of . goods on credit, and
deferment, on account of custom, usage or arrangement, of payment for expenses.. The remaining part of the need
for working capital may be met from short-term borrowing from financiers like banks. These items are collectively
called current liabilities. Typical items of current liabilities are:
Goods purchased on credit
Expenses incurred in the course of the business of the organisation (e.g.,
wages or salaries, rent, electricity bills, interest etc.) which are not yet paid for.
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 tax and dividends payable. Some of the major components of current assets
are explained here in brief:
Cash : All of us know that the basic input to start any business is cash. Cash is initially required for
acquiring fixed assets like plants and machinery which enables a firm to produce products and generate
cash by selling them. Cash is also required and invested in working capital. Investments in working
capital is required, as firms have to store certain quantity of raw materials and finished goods and also for
providing credit terms to the customers. A minimum level of cash helps in the conduct of everyday
ordinary business such as making of purchases and sales as well as for meeting the unexpected payments,
developments and other contingencies. As discussed earlier cash invested at the beginning of-the
operating cycle gets released at the end of the cycle to fund fresh investments. However, additional cash
is re quired by the firm when it needs to buy more fixed assets, increase the level of operations or for
bringing out change in working capital cycle such as extending credit period to the customers.
The demand for cash is affected by several factors, some of them are within the control of the
managers and some are outside their control. It is not possible to operate the business without holding
cash but at the same time holding it without a purpose also costs a firm either directly in the form of
interest or loss of income that could be earned out of the cash. In the context of working capital
management , cash management refers to optimizing the benefit and cost associated with hol ding cash.
The objective of cash management is best achieved by speeding up the working capital cycle,
particularly the collection process and investing surplus cash in short term assets in most profitable
avenues. We will be subsequently discussing certain issues like the management of cash flows and
determination of optimal cash balance, etc. (in this unit).
Accounts Receivable: Firms rather prefer to sell for cash than on credit, but competi-tive pressures force
most firms to offer cred it. Today the use of credit in the purchase goods and services is so common that
it is taken for granted. Selling goods or providing services on credit basis leads to accounts receivable.
When consumers expect credit, business units in turn expect credit from their suppliers to match their
investment in credit extended to consumers. The granting of credit from one business firm to another for
purchase of goods and services is popularly known as trade credit.Though commercial banks provide a
significant part of requirements for working capital, trade credit continues to be a major source of funds
for firms and accounts receivable that result from granting trade cr edit are major investment for the firm.
Both direct and indirect costs are associated with carrying receivables, but it has an important benefit for
increasing sales. Excessive levels of accounts receivables result in decline of cash flows and many result
in bad debts which in turn may reduce the profit of the firm. Therefore, it is very important to monitor
and manage receivables
carefully and regularly.

Inventory : Three things will come to your mind when you think of a manufacturing unit - machines,
men and materials. Men using machines and tools convert the materials into finished goods. The success
of any business unit depends on the extent to which these are efficiently managed. Inventory is an asset to
the organisation like other components of current assets. Inventory constitutes a very significant part of
working capital or current assets in manufacturing organisation. It is essential to control inventories
(physical/quantity control and value control) as these are significant elements in the costing process
constituting sometimes more than 60% of the current assets. Inventory holding is desirable because it
meets several objectives and needs but an excessive inventory is undesirable because it costs a lot to
firms. Inventory which consists of raw material components and other consumables, work in process
and finished goods, is an important component of `current assets'. There are several factors like nature of
industry, availability of material, technology, business practices, price fluctuation, etc. that determines
the amount of inventory holding. Holding inventory ensures smooth production process, price stability
and immediate delivery to customers. Since inventory is like any other form of assets, holding inventory
has a cost. The cost includes opportunity cost of funds blocked in inventory, storage cost, stock out cost,
etc. The benefits that come from holding inventory should exceed the cost to jus tify a particular level of
inventory.