Components of Working Capital - Essay Example

Managing Finance Part A: Working Capital Working capital is basically what an investor/entrepreneur/business owner is left with after deducting current liabilities from current assets. It is an indication of the liquidity of any business. More the working capital, more liquid is the business thought to be. Companies that have a good working capital can do their day-to-day functions well and their operating expenses have a good amount to get covered by. (Working Capital Definition, 2008) Many companies with even good profitability figures, face problems in running and dealing with their short- term debts and liabilities. To make sure that a business keeps running itself efficiently, it is of high importance that it manages its working capital in a good way too. And that's when it is said that this particular business is having cash-flow problems. The daily operations working capital is used to manage include, stock purchases, salaries and wages, heating and lighting expenses, funding of credit sales etc. (McKosker, Philip, March 1, 2000) Components of Working Capital Components of working capital include all those things that form part of the definition of working capital since working capital equals current assets less current liabilities, all those things that are categorized under these two things can be called a component of working capital. The three main components namely are, inventory, payables and receivables. (Managing Working Capital, n.d.) Inventory here includes all the stock, opening plus closing. (Managing Working Capital, n.d.) Inventory also includes raw materials,work-in-progress stock of goods and even finished stock of goods. These all are categorized under the assets portion on a business balance sheet. (Inventory, 2008) Inventory payables refers to a business's creditors who are those people or institutions from where you borrow loans or buy good/stock from on credit. A creditor is hence an organization or person who gives out credit to other businesses. A business pays these people at the end of a term or after a set time period as arranged or agreed upon through a contract. (Creditor, 2008) Receivables, on the other hand are those people or organizations that owe the business rather. This usually happens when a business gives out goods or stock of finished goods on credit to people who cannot pay at that point in time. Hence, they are termed as debtors. Just like creditors, businesses form a contract with them too which states how much money ahs been given, for how long, for what and when will it have to be repaid etc. (Money You are Owed, 2004). There are sources of working capital. These are called parts of working capital of a business. These are: cash held in reserve in the business, band OD (over-draft), remaining or retained profits, loans, credit attained from creditors, and long-term loans. (Managing Working Capital, n.d.) 'Control of working capital has always been thought to be the most important factor in the short-term financial management of companies' This statement, I believe is very much true for businesses working today. These days as competition amongst companies has been soaring up almost perpetually, it is highly important for these companies to manage their working capital well. It does not just depend or vary from one economic situation to another, rather on he basic fact that these companies all need to survive first and foremost. Hence, managers or financial executives or anyone who has the work of managing cash flows for a business aims to maximize working capital and get more value for money generally. Another way to say this is through acquiring more worth for short-term cash or cash as a business' current asset. (Bauer, Dennis, 2007). It is highly imperative for these managers to handle each component of working capital efficiently. These components have already been discussed above. (Working Capital, n.d.) It is often said that working capital is the lifeblood of an organization. It holds so much information that it is sometimes claimed even more important than profits. If a business does not have enough cash at hand and cash in the bank, it will eventually run out of business. Good working capital management or good cash flow management is absolutely essential hence to improve profits, make better a business's liquidity condition. If a business does not have enough cash o run it, then it will not be in a situation that will generate it good profits also. A reason why there has been a great increase in demand for leasing and other financing solutions has also been because of the basic fact that working capital is so highly important to the functioning of a business. It is hence intelligent when running a business to make sure that not all cash is spent on things like land, plant, vehicles etc rather much is saved so that everyday expenses and other operating expenses are met when their payments become due. A business can also become less liquid if cash is spent on everything. Too many cash outflows for instance because of payment of dividends etc can make the liquidity position of a business bad, hence rendering it more prone to risks of closing and other business risks like take-over, legal issues etc. (Managing Working Capital, n.d.) Part B: Factoring for business: Factoring for business is basically an alternative to busying an asset normally. Whenever there's factoring involved, the factor company offers goods on credit by buying that risk that is involved in credit buying. Factoring is also a very efficient way to manager cash flows. Factoring can benefit companies by making sure that there is enough working capital for a business to meet its cash flow necessities. (Factoring, n.d.) Whenever, a sale of a good or service or asset is involved, and there is accounts receivable option available for immediate cash, then factoring again is a good carefree option. Factoring companies are there who function only to serve this "factoring purpose". Easy access to cash and improved cash flows are hence the results of the use of factoring in businesses. This can ultimately be put to use in the expansion and growth of that business which ahs made use of factoring, without the costs and risks pertaining to dilution due to liquidity problems. (Wayne Caskey, 1998) Factoring is very useful to organizations hence, as above mentioned. It can also be specifically be used in speeding up payments. Whenever, there's a risk involved that the person won't pay the business or is delaying it, and then these factoring companies can be immensely useful to companies for getting payments out. This they do by buying the credit that is owed by those organizations to the business. And then these businesses pay the factoring companies and not the company itself. A factoring company however takes a charge for that. For example, advance rates that are basically the percentage of invoice that is paid before collection or advance invoices. These have differing rates of risks involved depending on the type of industry operating in, the sort of factoring firm involved and the type of risk. Transactions involved with the factoring firm can be both "recourse and non- recourse". This means, these can be through the mere replacement of receivable and the period decided is according to the contract that is involved. (Wayne Caskey, 1998) Any business that has invoices and a credit system for its customers can explore the option of factoring. Even businesses like hardware stores, dry cleaners, security agencies, florists, hair-dressers, etc all are capable of using factoring since they can also have an invoice system. Payroll deadlines can hence be met when they become due. (Who Uses Factor Services, n.d.) Particular benefits derived from factoring are: - Better and an easy management of cash. More accessibility of cash Purchase capital goods Put that cash for expansion purposes Apply for discounts by paying suppliers on time Keep businesses running and buoyant Meet tax requirements on time (VendorSeek, n.d.) But, on the downside, factoring can also prove to be more expensive, more time-sensitive and could even prove detrimental to the relationship structure between businesses that might have been functioning fairly well with each other previously. Works Cited 1. Working Capital Definition (2008) [Internet] Available from: http://www.investorwords.com/5334/working_capital.html [Accessed August 9, 2008]. 2. McKosker, Philip (March 1, 2000) The importance of working capital. [Internet] Financial Management Publication. Available from allbusiness Web site: http://www.allbusiness.com/accounting/926538-1.html [Accessed August 9, 2008]. 3. Managing Working Capital. (n.d.) [Internet] Available from: http://www.planware.org/workingcapital.htm [Accessed August 9, 2008]. 4. Inventory (2008) [Internet] Available from: http://www.investopedia.com/terms/i/inventory.asp [Accessed August 9, 2008]. 5. Creditor (2008). [Internet] Available from: http://www.investorwords.com/1207/creditor.html [Accessed August 9, 2008]. 6. Money You are Owed. (2004). [Internet] Available from: http://www.shoalcoast.org.au/faq/creditor.html [Accessed August 9, 2008]. 7. Bauer, Dennis (Oct, 2007). Working Capital Management. [Internet] Available from: http://www.allbusiness.com/company-activities-management/operations-billing/5503072-1.html [Accessed August 9, 2008]. 8. Working Capital. (n.d.) [Internet] Available from: http://www.bized.co.uk/learn/business/accounting/busaccounts/notes/wcap-th.gif [Accessed August 9, 2008] 9. Factoring. (n.d.) [Internet] Available from Factorchoice Web site: http://www.factorchoice.net/FAQ.asp [Accessed August 9, 2008]. 10. Wayne Caskey (1998). [Internet] Factoring- The Creative Alternative Financing Mechanism. Available from MoreBusiness Web site: http://www.morebusiness.com/running_your_business/financing/factor.brc [Accessed August 9, 2008]. 11. Who Uses Factor Services (n.d.) [Internet] Available from: http://www.buyerzone.com/finance/factoring/buyers_guide3.html [Accessed August 9, 2008]. 12. VendorSeek (n.d.) [Internet] Available from: http://www.vendorseek.com/benefits-of-factoring.asp [Accessed August 9, 2008]. Read More