Question

1. What are the components of Balance Sheet? Explain the relationship between the components.
2. What is net working capital? Elaborate on how to use it to evaluate a company for its sufficiency of working capital. Can we compare two different-size companies with working capital? Why, or why not?
3. What is the cash operating cycle? What are its components? Explain the relationship between the components.

Answer 1

1. Components of Balance sheet and relationship between the components :

The three components of balance sheet are : a) Assets b) Liabilities c) Shareholders' Equity

Each component has been described briefly below :

a) Assets : These are resources or things of value which the company owns and which provide "future economic benefit" to the entity. Examples include Cash & Cash equivalents, Accounts Receivables, Property, Plant & Equipment etc.

b) Liabilities : These are debts owed by the company to the creditors such as Outstanding Expenses Payable, Accounts Payable, Loan/Borrowings etc.

c) Shareholders' Equity : Equity of a company represents the retained earnings and the funds contributed by the owners. Owners are the ones who accept the uncertainty with the huge risk in the hope that they will get very good returns.

Relationship among the above components is as follows :

Total Assets = Total Liabilities + Shareholders' Equity

The meaning of this equation is very important. These components are inter-related. Generally a high sales growth requires a larger asset base, i.e., it requires more fixed assets, inventory etc. Also as a company grows it's assets, it also tends to grow its liabilities and equity as the company has to get the money from somewhere to grow its assets.

The above relationship is also very clear from the structure of balance sheet explained below :

Balance Sheet as on 31/12/XX
Particulars	Amount	Particulars	Amount
Total Liabilities	XX	Total Assets	XX
Equity	XX
Total	XX	Total	XX

Both sides of the balance sheet always have to be matched. If they are not matching there is some kind of misstatement in the accounts.

2. For understanding net working capital, let's first understand a bit about what are current assets and current liabilities.

Current Assets are assets which are expected to be realized or consumed within the normal operating cycle of the business whereas Current liabilities are liabilities are liabilities which are expected to be paid within the normal operating cycle of the business.

Net working capital is the difference between a company's current assets and current liabilities.

It can be easily used to elaborate on the sufficiency of the company's working capital. A positive net working capital says positive things about the liquidity position of the company as it indicates that the company's current assets are higher than the current liabilities, i.e. the company has enough assets to meet its current obligations and also invest the surplus funds however and whenever required.

No, we cannot compare 2 different size companies' working capital as the large sized firm might have a higher working capital in monetary terms but might also have equally higher current liabilities and might be in a worse position as compared to the small sized firm.

One of the most effective ways to compare two businesses is to perform a ratio analysis on each company's financial statements. Similarly, even for working capital, we have a financial ratio known as "Current Ratio" which is used for comparing working capital of any 2 firm of any size. Current Ratio = Current Assets/Current Liabilities. Generally a current ratio above 1 is a positive sign. The company with a higher current ratio is in a better position to meet its current obligations and is better in terms of working capital.

3. Cash operating cycle, also known as cash conversion cycle, refers to the length of time between which a company purchases the raw materials and the cash is received from the accounts receivables/customers. It is the time required for a business to turn purchases into cash receipts from customers.

3 components : There are basically 3 components of the cash operating cycle : a) Inventory turnover days (Days of Inventory Outstanding) b) Accounts Receivable Turnover Days (Days Sales outstanding) c) Payable turnover days (Days payable outstanding)

It can also be explained with the help of formula for converting the cash operating cycle which is as follows :

CCC=DIO+DSO−DPO

Where: DIO=Days of inventory outstanding

DSO=Days sales outstanding

DPO=Days payables outstanding​

Relationship between components of cash conversion cycle :

DIO calculates the number of days the company the holds the inventory before selling it and DSO is a financial measure of how much time it takes for the company to collect payment from customers after the sale has been made. DIO and DSO are associated with the company's cash inflows and hence positive in the above formula whereas DPO which represents the average time the company takes to pay its bills is linked with the company's cash outflows and hence appears as negative in the formula above. Another way to look at it is that DIO and DSO are linked to inventory and accounts receivable, which are considered as short-term assets and hence are taken as positive whereas DPO is linked to accounts payable, which is a liability, and thus taken as negative.