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 one 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 maintain day to day cashflow. It requires enough to pay for wages & salaries because they fall due & enough to cover creditors should it be 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 eventually too. Also a profitable company may fail if it does not have adequate cash flow to satisfy its liabilities since they fall due.
What exactly is Working Capital Management? Make certain that sufficient liquid resources are maintained is dependent on capital management. This involves achieving a balance between the requirement to lower the risk of insolvency and the requirement to increase the return on assets .An excessively conservative approach resulting in high degrees of cash holding will harm profits because the opportunity to create a return on the assets tide up as cash may have been missed.
The amount of Current Assets Required. The quantity of current assets required will be based on the nature in the company business. As an example, a manufacturing company might require more stocks than company in a service industry. Since the amount of output with 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 specific amount 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 allow for safety or buffer stocks) easier credit & sizable cash holding (For precautionary reasons).
Over-Capitalization. If you can find excessive stocks debtors & cash & very few creditors there may 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 needs to be, & long term funds will be unnecessarily tide up when they could be invested elsewhere to generate income.
Over capitalization regarding working capital should not exist when there is good management however 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 include the following.
Sales /working capital. The quantity of sales being a multiple from the working capital investment should indicate weather, in comparison to previous year or with a similar companies, the complete worth of working capital is simply too high.
Liquidity ratios. A current ratio greater 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 a short duration of credit extracted from supplies, might indicate that the level of stocks of debtors is unnecessarily high or the volume of creditors too low.