What 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 including 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 keep daily cash flow. It needs enough to pay wages & salaries since they fall due & enough to pay creditors when it is to keep its workforce & ensure its supplies. Maintaining adequate working working capital is not only important in the short term. Sufficient liquidity has to be maintained to guarantee the survival from the business in the long run also. 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 lower the potential risk of insolvency as well as the requirement to maximize the return on assets .An excessively conservative approach resulting in high amounts of cash holding will harm profits because the chance to make a return on the assets tide as cash will have been missed.
The volume of Current Assets Required. The amount of current assets required will depend on the nature in the company business. As an example, a manufacturing company may require more stocks than company in a service industry. Since the volume of output with a company increases, the amount of current assets required will even increase.
Even assuming efficient stock holdings, debt collection procedures & cash management, there is still a specific degree of choice in 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 permit for safety or buffer stocks) easier credit & sizable cash holding (For precautionary reasons).
Over-Capitalization. If there are excessive stocks debtors & cash & not many creditors there will an over investment through the company in current assets. It will probably be excessive & the business are usually in this respect over-capitalized. The return on the investment is going to be below it should be, & long lasting funds will likely be unnecessarily tide up when they may be invested elsewhere to earn profits.
Over capitalization with respect to working capital should not exist when there is good management but the warning since excessive working capital is poor accounting ratios. The ratios which can assist in judging if the investment linrmw working capital is reasonable are the following.
Sales /working capital. The volume of sales as a multiple of the working capital investment should indicate weather, in comparison with previous year or with similar companies, the total worth of working capital is just too high.
Liquidity ratios. A current ratio more than 2:1 or even a quick ratio greater than 1:1 might point to 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 the amount of stocks of debtors is unnecessarily high or perhaps the amount of creditors too low.