Precisely what 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 twelve months, & may include amounts owned to trade creditors, taxation payable, dividend payments due, short term loans, long-term debts maturing within one year & so on.
All businesses needs adequate liquid resources to keep up day to day cash flow. It requires enough to pay for wages & salaries because they fall due & enough to cover creditors if it is to help keep its workforce & ensure its supplies. Maintaining adequate working working capital is not only important in the short term. Sufficient liquidity should be maintained to make sure the survival in the business in the long term too. Also a profitable company may fail if it lacks adequate cashflow to fulfill its liabilities since they fall due.
What exactly is Working Capital Management? Make sure that sufficient liquid resources are maintained is a point of capital management. This requires achieving a balance involving the requirement to lower the potential risk of insolvency as well as the requirement to increase the return on assets .An excessively conservative approach resulting in high amounts of cash holding will harm profits because the chance to produce a return on the assets tide up as cash will have been missed.
The amount of Current Assets Required. The amount of current assets required will be based on the nature from the company business. For example, a manufacturing company may require more stocks than company in a service industry. As the level of output with a company increases, the amount of current assets required will even increase.
Even assuming efficient stock holdings, debt collection procedures & cash management, there exists still a certain degree of choice in the total volume of current assets needed to meet output requirement. Policies of low stock-holding levels, tight credit & minimum cash holding could 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 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 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 may 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 may assist in judging whether or not the investment linrmw working capital is reasonable are the following.
Sales /working capital. The volume of sales as a multiple in the working capital investment should indicate weather, in comparison with previous year or with similar companies, the complete price of working capital is too high.
Liquidity ratios. A current ratio more 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 a short period of credit taken from supplies, might indicate the level of stocks of debtors is unnecessarily high or even the volume of creditors too low.