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 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, temporary loans, long term debts maturing within one year & so on.
Every business needs adequate liquid resources to keep daily cashflow. It deserves enough to cover wages & salaries because they fall due & enough to cover creditors if 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 make sure the survival from the business eventually too. Even a profitable company may fail when it does not have adequate cashflow to fulfill its liabilities as they fall due.
What exactly is Working Capital Management? Make certain that sufficient liquid resources are maintained is a matter of capital management. This requires achieving a balance between the requirement to lower the chance of insolvency and the requirement to optimize the return on assets .An excessively conservative approach leading to high amounts of cash holding will harm profits because the chance 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. For instance, a manufacturing company may require more stocks than company in a service industry. Since the level of output by a company increases, the volume of current assets required will also increase.
Even assuming efficient stock holdings, debt collection procedures & cash management, there exists still a specific amount of choice within the total amount 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 enable for safety or buffer stocks) easier credit & sizable cash holding (For precautionary reasons).
Over-Capitalization. If there are excessive stocks debtors & cash & very few creditors there will probably an over investment through the company in current assets. It will likely be excessive & the business will be in this respect over-capitalized. The return on the investment will be below it ought to be, & long-term funds will likely be unnecessarily tide up when they may be invested elsewhere to earn profits.
Over capitalization with respect to working capital should never exist if there is good management however the warning since excessive working capital is poor accounting ratios. The ratios which may aid in judging whether or not the investment linrmw working capital is reasonable include 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 greater 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 a short period of credit extracted from supplies, might indicate that this volume of stocks of debtors is unnecessarily high or even the volume of creditors too low.