Question

Define working capital and explain how it affects the flow of a firm’s resources through the cash, accounts receivable, and inventory accounts.

Compare your take home pay with the working capital of a business.

If you loan $50 to a friend expecting to be paid back in 7 days. Then the friend “forgets” to pay the money back. What does that do to your individual cash flow?

Ok, what happens as the length of time that you keep waiting to be repaid the $50 grows longer?

Answer 1

Define working capital and explain how it affects the flow of a firm’s resources through the cash, accounts receivable, and inventory accounts.

Compare your take home pay with the working capital of a business.

If you loan $50 to a friend expecting to be paid back in 7 days. Then the friend “forgets” to pay the money back. What does that do to your individual cash flow?

Ok, what happens as the length of time that you keep waiting to be repaid the $50 grows longer?

Working capital is primarily defined as the amount of money required to run the day to day business while managing all stakeholders such as customer, suppliers, banks, employees, etc.

Accounts receivables for example is the amount of money we have to receive from our customers for the goods/services supplied. If the accounts receivables do not go down, i.e there is delay in receiving money from customers, our working capital gets stuck and we need to arrange money from other sources eg. bank to meet our liabilities

Inventory is again something that impact working capital. Our inventory is an indication of the amount invested in manufacturing our goods. If the inventory is sold, we are able to move/reduce our inventory and convert the same to cash via accounts receivables and our working capital is improved. However, if we are unable to sell our inventory, again working capital gets stuck and cash is required from other sources

One of the major sources of working capital financing is banks who lend us money to take care of the fluctuations in the inventory, accounts recivables and accounts payable. The lending from banks ensure that our working capital is smoothened and there are no sudden shocks.

Consider our take home pay vs working capital of a business. Our take home pay is basically an amount we received from our employer that they owed us for the work we did for them. Further, we have certain liabilities of ours such as payment of several expenses as well as making investments that are done once we receive the pay. In short we are receving cash from our employers and managing our working capital through discharging our liabilies as well as investing money and/or keeping some money in cash. Again if the salary paid by our employer is not sufficient or our liabilities are too large, we may end up taking a personal loan from the bank to take care of these liabilities and serve the loan through furute EMI/interest repayments.

If we pay a friend $50 for a period of 7 days, we expect that the understanding will be honored. As an individual, this may be not a very big amount and hence a liability to start of with. It may to an extent impact my working capital becuase I may have planned to use this $50 for something else which now I have to wait another 7 days to do. Hence, if the friend forgets to pay back the $50 in 7 days, my monthly cashflow starts getting impacted and I have create an alternate plan where I have to consider this $50 to be received in the future and make do with $50 less today. Hence, the apportionment that I had planned to do with my income to start of with for a particular month will have this $50 less now.

As length of time that I keep waiting to be repaid the $50 grows longer, I keep realizing that this amount is becoming a non-moving entity in my plan. Not only am I not gaining any interest on the same (since I had lend it to my friend interest free off-course) but also I have to expect this cash inflow in my plan with the uncertainty if receiving it. This amount in due course of time may be something that may park as 'bad debt' in accounting language, meaning that I am expecting never to receive it. My overall cashflow thus will have this $50 permanently deleted from it eventually.