Precisely 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 including 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 term debts maturing within 1 year & so on.
All businesses needs adequate liquid resources to keep day to day cashflow. It deserves enough to cover wages & salaries since they fall due & enough to cover creditors if it is to maintain its workforce & ensure its supplies. Maintaining adequate working working capital is not only important for the short term. Sufficient liquidity has to be maintained in order to ensure the survival in the business eventually as well. A profitable company may fail if it lacks adequate cash flow to fulfill its liabilities because they fall due.
What exactly is Working Capital Management? Make sure that sufficient liquid resources are maintained is dependent on capital management. This involves achieving a balance between the requirement to lower 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 create a return on the assets tide up as cash could have been missed.
The volume of Current Assets Required. The amount of current assets required will be based on the nature of the company business. For example, a manufacturing company might require more stocks than company in a service industry. As the level of output with a company increases, the volume of current assets required will also increase.
Even assuming efficient stock holdings, debt collection procedures & cash management, there is certainly still a specific level of choice within the total volume of current assets required 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 will find excessive stocks debtors & cash & very few creditors there may an over investment through the company in current assets. It will probably be excessive & the business are usually in this respect over-capitalized. The return on the investment will likely be lower 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 with regards to working capital should not exist if you have good management but the warning since excessive working capital is poor accounting ratios. The ratios which could assist in judging if the investment linrmw working capital is reasonable are the following.
Sales /working capital. The amount of sales being a multiple of the working capital investment should indicate weather, in comparison with previous year or with a similar companies, the entire value of working capital is simply too high.
Liquidity ratios. A current ratio more than 2:1 or perhaps 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 period of credit taken from supplies, might indicate that this level of stocks of debtors is unnecessarily high or even the level of creditors too low.