What exactly is working Capital? In a business it can be defined 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 one year, & may include amounts owned to trade creditors, taxation payable, dividend payments due, short term loans, long term debts maturing within one year & so on.
Every business needs adequate liquid resources to maintain daily cashflow. It deserves enough to cover wages & salaries because they fall due & enough to pay for creditors when it is to maintain its workforce & ensure its supplies. Maintaining adequate working working capital is not just important in the short term. Sufficient liquidity must be maintained to make sure the survival of the business in the long term too. Also a profitable company may fail if it does not have adequate cashflow to fulfill its liabilities because they fall due.
Precisely what is Working Capital Management? Ensure that sufficient liquid resources are maintained is a matter of capital management. This involves achieving a balance involving the requirement to reduce the potential risk of insolvency as well as the requirement to increase the return on assets .An excessively conservative approach leading to high levels of cash holding will harm profits because the opportunity to make a return on the assets tide up 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. For example, a manufacturing company might require more stocks than company in a service industry. Since the volume of output by way of a company increases, the volume of current assets required will also increase.
Even assuming efficient stock holdings, debt collection procedures & cash management, there is still a specific level of choice inside the total volume of current assets needed to meet output requirement. Policies of low stock-holding levels, tight credit & minimum cash holding may be contrasted with policies of high stock (To allow for safety or buffer stocks) easier credit & sizable cash holding (For precautionary reasons).
Over-Capitalization. If you will find excessive stocks debtors & cash & only a few creditors there will probably an over investment through the company in current assets. It will likely be excessive & the company are usually in this respect over-capitalized. The return on the investment will likely be less than it needs to be, & long-term funds will be unnecessarily tide up when they might be invested elsewhere to earn profits.
Over capitalization with regards to working capital should never exist if you have good management but the warning since excessive working capital is poor accounting ratios. The ratios which could aid in judging whether the investment linrmw working capital is reasonable range from the following.
Sales /working capital. The quantity of sales being a multiple of the working capital investment should indicate weather, when compared with previous year or with similar companies, the total price of working capital is simply too high.
Liquidity ratios. A current ratio more than 2:1 or perhaps a quick ratio more than 1:1 may indicate over-investment in working capital. Turnover periods. Excessive turnover periods for stocks & debtors, or perhaps a short time of credit taken from supplies, might indicate that the amount of stocks of debtors is unnecessarily high or perhaps the volume of creditors too low.