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 lasting debts maturing within twelve months & so on.
Every business needs adequate liquid resources to maintain day to day income. It needs enough to cover wages & salaries since they fall due & enough to pay creditors when it is to maintain its workforce & ensure its supplies. Maintaining adequate working working capital is not just important for the short term. Sufficient liquidity has to be maintained to guarantee the survival of the business in the long term also. Also a profitable company may fail if it lacks adequate cashflow to fulfill its liabilities since they fall due.
Precisely what is Working Capital Management? Ensure that sufficient liquid resources are maintained is a matter of capital management. This requires achieving a balance involving the requirement to lower the risk of insolvency as well as the requirement to optimize the return on assets .An excessively conservative approach leading to high degrees 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 quantity of Current Assets Required. The volume of current assets required will be based on the nature from the company business. For instance, a manufacturing company may require more stocks than company in a service industry. As the level of output by a company increases, the quantity of current assets required may also increase.
Even assuming efficient stock holdings, debt collection procedures & cash management, there is still a particular degree of choice in the total amount 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 will find excessive stocks debtors & cash & not many creditors there will probably an over investment through the company in current assets. It will probably be excessive & the business will be in this respect over-capitalized. The return on the investment is going to be lower than it needs to be, & long-term funds is going to be unnecessarily tide up when they might be invested elsewhere to generate income.
Over capitalization with respect 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 can help in judging whether the investment linrmw working capital is reasonable include the following.
Sales /working capital. The quantity of sales being a multiple in the working capital investment should indicate weather, in comparison to previous year or with a similar companies, the entire price of working capital is just too high.
Liquidity ratios. A current ratio in excess of 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 the amount of creditors too low.