The study of the structure of working capital refers to the actual composition of the items making up the working capital. As such, it depends upon the amount of individual current assets and current liabilities. The term Current Assets generally refers to those assets which in the ordinary course of business can be turned in to cash within a short period of one accounting year without undergoing a diminution in value and without disrupting the operations of the firm. The major current assets are: Inventory, Receivables and Cash. On the other hand, Current Liabilities are those liabilities which are intended at their inception to be paid in the ordinary course of business within a short period of one accounting year, out of the current assets or earnings of the firm. The basic current liabilities are Bank Credit, Trade Credit and Other Short-term Sources of Fund. The major components of both current assets and current liabilities are explained here under:
1. Current Assets
Inventory generally occupies the most strategic position in the structure of working capital of business enterprises. Maximization of income and profit mainly depends upon the turnover of working capital, which in turn is mostly determined by the turnover of inventory. It may therefore be recognized as the most important item of current assets of a business enterprise. Generally inventory is composed of assets what will be sold in future in the normal course of business operations. The assets, which form stores as inventory in anticipation of need, are:
a. Raw material inventory, which contains items that are purchased by the firm from others and are converted into finished goods through the manufacturing process,
b. Work-in-process inventory, which consists of items that are currently being used in the production process and
c. Finished goods, which represent final or completed products available for sale. In any business, the extreme level of inventory, i.e., too high or too low is always undesirable. If being a very important component of working capital, proper inventory management is necessary, which generally requires arriving at a balance between inventory carrying cost and adequately meeting demand.
Like inventory, receivable also occupies an important position in the structure of working capital. The term Receivable is may be termed as a debt owed to the firm by the customers arising from sale of goods or services in the ordinary course of business. When a firm makes an ordinary sale of goods or services and does not receive payment, the firm grants trade credit to its customers and creates accounts receivable, which would be collected in future. Generally credit sales and therefore receivables are treated as an essential marketing tool to aid the sales of goods in today’s competitive economic system. In fact, very few firms usually operate on a “cash and carry” basis. However, extension of credit involves both risk and cost. Therefore, the objective of receivable management should be to balance profits and receivables where equilibrium is to be maintained between the two aspects with a caution to maintain less receivables for the hygiene of industry.
Cash, the most liquid asset, is of vital importance to the daily operations of business firms. It is both a means and an end of business enterprises. In a financial sense, the term ‘cash’ refers to all money items and sources that are immediately available to help pay a firm’s bill. Cash includes over and above what is kept in the hand, is in the form of bank accounts, demand deposits, call loans and time deposits etc.
Cash management must aim to reduce the required level of cash but minimize the risk of being unable to discharge claims against the company as they arise. Therefore, the firm should maintain on optimum cash balance which is neither small nor large. It is that balance where the liquidity and profitability goals meet and there is a trade-off between the risk and return which is associated with too small or too much of cash balance.
2. Current Liabilities
Bank loans are conventionally treated as current. The loans may be in the form of cash credit, bills or overdrafts. Bank loans against mortgage are usually for longer period than that of one year. Banks allow the practice of rolling over of loans by renewal. So, before final inclusion of bank loans as short term, the nature of contract and fluctuations are to be scrutinized.
This is an important component of current liability. Outstanding accounts of the suppliers comprise trade credit. Raw materials are usually purchased on credit. However, the amount of trade credit is governed mainly by the degree of competition and usage of the trade.
Other Current Liabilities
This item comprises all sort of short term obligations which are not bank loans or trade credits. They include the following:
1. Accrued Expenses Accrued expenses are those which have been incurred but not paid. These are short term liabilities.
2. Proposed Dividends Proposed dividend is declared at the time of Annual General Meeting of a company. When the dividend is declared, it becomes liability of the company. Till the period of payment of declared dividend, the same is treated as current liability.
3. Tax Provision Any tax which is due for payment within a period of one year is a current liability.
The above discussion on the various components of working capital reveals that current assets are not the only components which count in the framing of the structure of working capital. On the Liabilities side, the arrangements in connection with bank borrowings are important and also the arrangements made from time to time with creditors are equally vital. Together with these, the handling of unpaid dividends and assessed tax is also crucial. The focus of arrangement is therefore restricted to the handling of current assets.
For citing this article use:
- Somanchi, H. K. (2013). A comparative study on working capital management in pharmaceutical industry.