What Are the 4 Main Components of Working Capital?
Working capital is easy enough to understand on a surface level. However, creating a successful strategy for short-term financing involves more than memorizing the working capital management formula and learning how to calculate working capital.
Before jumping into the working capital management process, a company must first develop an in-depth understanding of the components of working capital and evaluate how each component impacts current and future business goals. After this initial step is taken, a business can begin to formulate a successful strategy to ensure that:
All day-to-day operating expenses are covered
All assets are effectively invested and managed
So, what are the components of working capital? And how does each component impact a business?
Four Main Types of Working Capital Components
In total, there are four working capital components that businesses need to monitor in order to create and maintain a robust cash flow.
Accounts Receivable
Accounts receivable include all payments that are owed to a business. This includes revenue from sales as well as debts owed to a company by vendors and other partners. In order to maintain a healthy working capital balance, businesses need to collect these funds as soon as possible in order to pay for immediate expenses like operational costs. However, payments only become an asset if they are collected.
As a best practice, businesses should make a point to collect what is owed to them as soon as possible without damaging their relationships with partners and customers. According to Investopedia, most companies are able to collect their receivables within 30 days. That being said, each receivable timeline looks different for every business and is highly situational. Before devising a working capital management framework, company leaders should investigate their current and past receivable practices and compare them to others in the industry.
Accounts Payable
The opposite of accounts receivable, a company’s accounts payable amount includes all of the debts that must be paid off in the short term. A stable company will be able to effectively maintain a balance between its payments and receivables. This maximizes a business’s cash flow and prevents debts from piling up too high. Depending on the industry, most companies are able to delay their payments to some degree, so long as hard deadlines are met and business relationships are maintained.
Cash Balance
A company’s cash balance is possibly the most important part of a company’s current assets and greatly impacts a business’s liquidity. This includes regular cash income and other liquid securities that are cash-convertible. A well-stocked cash reserve functions as an invaluable resource to cover day-to-day expenses and other incidentals as they arise. Cash equivalents are also included in this category. Here are a few examples:
Certificates of deposit
Money market funds
Cash management pools
Inventory
How quickly a company is able to replenish and sell its inventory correlates with how successful its sales are. Like most things in business, establishing constant equilibrium is of vital importance. When it comes to managing inventory, maintaining a balance between selling and purchasing will help support your working capital. High inventory means a company is wasting money on too many supplies, whereas low inventory indicates that a business is in danger of missing out on sales opportunities. Closely monitoring inventory allows leaders to determine the efficiency of their sales and manufacturing strategies and identify potential issues in each process. Inventory accounts for a range of assets like:
Maintenance, Repair, and Operations (MRO) inventory
Raw materials
Finished goods
Cycle stock
What Is the Most Important Component of Working Capital?
Out of the four components we listed above, all are equally important. Successful working capital management is all about vigilance and proactive planning. Neglecting to monitor each of these components and observing their impact on your working capital means your company will fail to meet minimum working capital requirements.
Strengthening Your Working Capital With a Partner Who’s Invested in Your Success
Successfully tackling working capital in financial management means exploring different methods of covering expenses so your assets are protected and your liabilities are minimized. This can often feel overwhelming without the right support. At Backd we’re dedicated to giving businesses the support they deserve to boost their immediate spending power. With over 3,700 business partners, we have extensive experience in creating alternative financing strategies to meet the specific needs of your business. Our competitive rates and flexible terms are designed to work in your favor, no matter your situation. Fill out our application or reach out to us to discover a solution that works for you today!
