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 like Treasury bills & amounts receivable from from debtors. Current liabilities comprise creditors falling due within 1 year, & may include amounts owned to trade creditors, taxation payable, dividend payments due, temporary loans, long term debts maturing within twelve months & so on.
All businesses needs adequate liquid resources to keep day to day income. It needs enough to pay for wages & salaries because they fall due & enough to pay creditors when it is to help keep its workforce & ensure its supplies. Maintaining adequate working working capital is not just important in the short term. Sufficient liquidity should be maintained in order to ensure the survival of the business eventually too. Even 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 dependent on capital management. This involves achieving a balance in between the requirement to reduce the risk of insolvency as well as the requirement to increase the return on assets .An excessively conservative approach leading to high degrees of cash holding will harm profits because the chance to produce a return on the assets tide up as cash could have been missed.
The quantity of Current Assets Required. The amount of current assets required will depend on the nature of the company business. As an example, a manufacturing company may need more stocks than company in a service industry. As the volume of output by way of a company increases, the quantity of current assets required will also increase.
Even assuming efficient stock holdings, debt collection procedures & cash management, there is still a specific degree of choice inside the total volume of current assets necessary 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 you can find excessive stocks debtors & cash & only a few creditors there will probably an over investment by the company in current assets. It will be excessive & the organization are usually in this respect over-capitalized. The return on the investment will likely be less than it should be, & long-term funds will be unnecessarily tide up when they could be invested elsewhere to generate income.
Over capitalization with regards to working capital should not exist if you have good management however the warning since excessive working capital is poor accounting ratios. The ratios which could help in judging whether the investment linrmw working capital is reasonable include the following.
Sales /working capital. The amount of sales being a multiple in the working capital investment should indicate weather, in comparison to previous year or with similar companies, the complete price of working capital is just too high.
Liquidity ratios. A current ratio greater than 2:1 or even a quick ratio in excess of 1:1 may indicate over-investment in working capital. Turnover periods. Excessive turnover periods for stocks & debtors, or even a short duration of credit taken from supplies, might indicate the amount of stocks of debtors is unnecessarily high or even the level of creditors too low.