What exactly 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, short-term loans, long-term debts maturing within twelve months & so on.
Every business needs adequate liquid resources to maintain day to day cash flow. It requires enough to pay for wages & salaries because they fall due & enough to pay creditors if it is to maintain its workforce & ensure its supplies. Maintaining adequate working working capital is not just important for the short term. Sufficient liquidity must be maintained to guarantee the survival from the business in the long term as well. Even a profitable company may fail if it does not have adequate cash flow to satisfy its liabilities as they fall due.
What is Working Capital Management? Make certain that sufficient liquid resources are maintained is dependent on capital management. This requires achieving a balance between the requirement to minimize the potential risk of insolvency and also the requirement to increase the return on assets .An excessively conservative approach causing high amounts of cash holding will harm profits because the ability to make a return on the assets tide as cash may have been missed.
The amount of Current Assets Required. The quantity of current assets required will depend on the nature in the company business. For instance, a manufacturing company may require more stocks than company in a service industry. Because the volume of output with a company increases, the quantity of current assets required may also increase.
Even assuming efficient stock holdings, debt collection procedures & cash management, there exists still a particular level of choice in the total volume of current assets necessary to meet output requirement. Policies of low stock-holding levels, tight credit & minimum cash holding could 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 will find excessive stocks debtors & cash & very few creditors there will an over investment through the company in current assets. It will probably be excessive & the organization 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 likely be unnecessarily tide up when they could be invested elsewhere to generate income.
Over capitalization regarding 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 or not the investment linrmw working capital is reasonable include the following.
Sales /working capital. The volume of sales as a multiple of the working capital investment should indicate weather, in comparison to previous year or with similar companies, the total worth of working capital is too high.
Liquidity ratios. A current ratio greater than 2:1 or a quick ratio more than 1:1 might point to over-investment in working capital. Turnover periods. Excessive turnover periods for stocks & debtors, or even a short period of credit extracted from supplies, might indicate the level of stocks of debtors is unnecessarily high or the amount of creditors too low.