What exactly is working Capital? In a business it can be explained as its current assets less its current liabilities. Current assets comprise cash, stocks of raw materials, work in progress & finished goods, marketable securities such as Treasury bills & amounts receivable from from debtors. Current liabilities comprise creditors falling due within twelve months, & may include amounts owned to trade creditors, taxation payable, dividend payments due, short term loans, long-term debts maturing within twelve months & so on.
Every business needs adequate liquid resources to keep up everyday cashflow. It requires enough to pay for wages & salaries since they fall due & enough to cover creditors when it is to help keep its workforce & ensure its supplies. Maintaining adequate working working capital is not just important for the short term. Sufficient liquidity has to be maintained to guarantee the survival of the business in the long run too. Also a profitable company may fail when it lacks adequate cash flow to fulfill its liabilities because they fall due.
What exactly is Working Capital Management? Ensure that sufficient liquid resources are maintained is a matter of capital management. This requires achieving a balance between the requirement to minimize the potential risk of insolvency and the requirement to increase the return on assets .An excessively conservative approach leading to high amounts of cash holding will harm profits because the ability to make a return on the assets tide as cash could have been missed.
The quantity of Current Assets Required. The quantity of current assets required will be based on the nature of the company business. As an example, a manufacturing company may require more stocks than company in a service industry. Since the level of output by way of a company increases, the volume of current assets required may also increase.
Even assuming efficient stock holdings, debt collection procedures & cash management, there exists still a particular amount of choice in the total amount of current assets required to meet output requirement. Policies of low stock-holding levels, tight credit & minimum cash holding might be contrasted with policies of high stock (To permit for safety or buffer stocks) easier credit & sizable cash holding (For precautionary reasons).
Over-Capitalization. If you can find excessive stocks debtors & cash & not many creditors there may an over investment from the company in current assets. It will likely be excessive & the company will be in this respect over-capitalized. The return on the investment is going to be lower than it should be, & long-term funds will be unnecessarily tide up when they might be invested elsewhere to generate income.
Over capitalization with regards to working capital should never exist if you have good management nevertheless the warning since excessive working capital is poor accounting ratios. The ratios which may help in judging if the investment linrmw working capital is reasonable range from the following.
Sales /working capital. The volume of sales as a multiple from the working capital investment should indicate weather, in comparison to previous year or with similar companies, the total value of working capital is just too high.
Liquidity ratios. A current ratio more than 2:1 or a quick ratio in excess of 1:1 might point to over-investment in working capital. Turnover periods. Excessive turnover periods for stocks & debtors, or even a short time of credit obtained from supplies, might indicate that this volume of stocks of debtors is unnecessarily high or the volume of creditors too low.