What 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, short term loans, long lasting debts maturing within 1 year & so on.
All businesses needs adequate liquid resources to keep everyday cashflow. It deserves enough to pay wages & salaries because they fall due & enough to pay creditors when it is to keep its workforce & ensure its supplies. Maintaining adequate working working capital is not just important in the short term. Sufficient liquidity must be maintained in order to ensure the survival in the business in the long run as well. Even a profitable company may fail when it lacks adequate cash flow to meet its liabilities as they fall due.
What is Working Capital Management? Ensure that sufficient liquid resources are maintained is a point of capital management. This requires achieving a balance in between the requirement to lower the risk of insolvency and the requirement to increase the return on assets .An excessively conservative approach causing high levels of cash holding will harm profits because the ability to produce a return on the assets tide up as cash may have been missed.
The volume of Current Assets Required. The quantity of current assets required depends on the nature from the company business. For example, a manufacturing company may need more stocks than company in a service industry. Because the level of output by a company increases, the amount of current assets required will also increase.
Even assuming efficient stock holdings, debt collection procedures & cash management, there is certainly still a certain level of choice in the total amount of current assets needed to meet output requirement. Policies of low stock-holding levels, tight credit & minimum cash holding might 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 will 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 company are usually in this respect over-capitalized. The return on the investment will likely be lower than it ought to be, & long term funds will likely be unnecessarily tide up when they may be invested elsewhere to generate income.
Over capitalization with regards to working capital should never exist when there is good management however 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 being a multiple from the working capital investment should indicate weather, when compared with previous year or with a similar companies, the complete value of working capital is too high.
Liquidity ratios. A current ratio in excess of 2:1 or even 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 perhaps a short time of credit taken from supplies, might indicate that the amount of stocks of debtors is unnecessarily high or even the amount of creditors too low.