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 including 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 lasting debts maturing within twelve months & so on.
All businesses needs adequate liquid resources to keep up day to day cashflow. It needs enough to pay wages & salaries because they fall due & enough to cover 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 must be maintained in order to ensure the survival in the business in the long run too. Also a profitable company may fail when it does not have adequate income to meet its liabilities because they fall due.
What is Working Capital Management? Make sure that sufficient liquid resources are maintained is a point of capital management. This requires achieving a balance in between the requirement to lower the potential risk of insolvency and also the requirement to increase the return on assets .An excessively conservative approach resulting in high levels of cash holding will harm profits because the ability to create 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 will depend on the nature from the company business. As an example, a manufacturing company might require more stocks than company in a service industry. Because the amount of output by a company increases, the volume of current assets required will also increase.
Even assuming efficient stock holdings, debt collection procedures & cash management, there exists still a specific degree of choice inside the total volume of current assets required to meet output requirement. Policies of low stock-holding levels, tight credit & minimum cash holding might be contrasted with policies of high stock (To permit 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 will probably an over investment by the company in current assets. It will probably be excessive & the organization will be in this respect over-capitalized. The return on the investment will likely be below it needs to be, & long term funds will be unnecessarily tide up when they might be invested elsewhere to generate income.
Over capitalization with regards to working capital must not exist when there is good management nevertheless the warning since excessive working capital is poor accounting ratios. The ratios which can assist in judging if the investment linrmw working capital is reasonable are the following.
Sales /working capital. The amount of sales being a multiple in the working capital investment should indicate weather, when compared with previous year or with similar companies, the total price of working capital is simply too high.
Liquidity ratios. A current ratio greater than 2:1 or even a quick ratio in excess of 1:1 may indicate over-investment in working capital. Turnover periods. Excessive turnover periods for stocks & debtors, or a short time of credit taken from supplies, might indicate the level of stocks of debtors is unnecessarily high or the amount of creditors too low.