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 such as 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.
All businesses needs adequate liquid resources to maintain day to day cashflow. It deserves enough to pay wages & salaries as they fall due & enough to cover creditors should it be to maintain its workforce & ensure its supplies. Maintaining adequate working working capital is not only important in the short term. Sufficient liquidity must be maintained in order to ensure the survival in the business in the long term too. Also a profitable company may fail when it lacks adequate cash flow to meet its liabilities as they fall due.
What is Working Capital Management? Ensure that sufficient liquid resources are maintained is a point of capital management. This involves achieving a balance involving the requirement to reduce the chance of insolvency and the requirement to maximize the return on assets .An excessively conservative approach causing high degrees of cash holding will harm profits because the chance to create a return on the assets tide up as cash may have been missed.
The amount of Current Assets Required. The volume of current assets required will depend 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 amount of current assets required will even increase.
Even assuming efficient stock holdings, debt collection procedures & cash management, there is still a specific amount of choice in the total amount 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 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 by the company in current assets. It will likely be excessive & the business will be in this respect over-capitalized. The return on the investment will likely be below it ought to be, & long lasting funds is going to be unnecessarily tide up when they could be invested elsewhere to generate income.
Over capitalization regarding working capital should not exist when there is good management however the warning since excessive working capital is poor accounting ratios. The ratios which could aid in judging whether the investment linrmw working capital is reasonable range from the following.
Sales /working capital. The amount of sales as a multiple from the working capital investment should indicate weather, when compared with previous year or with similar companies, the complete worth of working capital is too high.
Liquidity ratios. A current ratio greater than 2:1 or a quick ratio more than 1:1 may indicate over-investment in working capital. Turnover periods. Excessive turnover periods for stocks & debtors, or perhaps a short period of credit obtained from supplies, might indicate the volume of stocks of debtors is unnecessarily high or perhaps the volume of creditors too low.