What exactly 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 keep up day to day cash flow. It deserves enough to pay for wages & salaries as they fall due & enough to pay creditors if it is to keep its workforce & ensure its supplies. Maintaining adequate working working capital is not only important in the short term. Sufficient liquidity has to be maintained to make sure the survival in the business in the long term as well. Also a profitable company may fail if it does not have adequate income to satisfy its liabilities because they fall due.
What exactly is Working Capital Management? Make certain that sufficient liquid resources are maintained is a matter of capital management. This involves achieving a balance between the requirement to minimize the potential risk of insolvency and the requirement to optimize the return on assets .An excessively conservative approach leading to high levels of cash holding will harm profits because the ability to make a return on the assets tide as cash will have been missed.
The volume of Current Assets Required. The quantity of current assets required will depend on the nature in the company business. For example, a manufacturing company may require more stocks than company in a service industry. As the level of output by a company increases, the amount of current assets required will even increase.
Even assuming efficient stock holdings, debt collection procedures & cash management, there is still a particular level of choice within the total amount 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 there are excessive stocks debtors & cash & only a few creditors there may 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 will likely be lower than it ought to be, & long lasting funds will be unnecessarily tide up when they might be invested elsewhere to earn profits.
Over capitalization with regards to working capital must not exist if there is good management however 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 include the following.
Sales /working capital. The volume of sales as being a multiple of the working capital investment should indicate weather, when compared with previous year or with similar companies, the entire worth of working capital is simply too high.
Liquidity ratios. A current ratio in excess of 2:1 or even a quick ratio greater than 1:1 might point to over-investment in working capital. Turnover periods. Excessive turnover periods for stocks & debtors, or even a short duration of credit extracted from supplies, might indicate that the volume of stocks of debtors is unnecessarily high or perhaps the amount of creditors too low.