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, temporary loans, long term debts maturing within twelve months & so on.
All businesses needs adequate liquid resources to maintain daily cashflow. It requires enough to pay for wages & salaries since 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 for the short term. Sufficient liquidity should be maintained to make sure the survival in the business eventually also. Also a profitable company may fail if this lacks adequate cash flow to meet its liabilities as 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 in between the requirement to lower the chance of insolvency as well as the requirement to optimize the return on assets .An excessively conservative approach resulting in high amounts of cash holding will harm profits because the chance to create a return on the assets tide up as cash will have been missed.
The volume of Current Assets Required. The amount of current assets required depends on the nature of the company business. For example, a manufacturing company may require more stocks than company in a service industry. Since the volume of output by a company increases, the amount of current assets required will also increase.
Even assuming efficient stock holdings, debt collection procedures & cash management, there is still a specific degree of choice in the total level 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 & only a few creditors there may an over investment from the company in current assets. It will likely be excessive & the business are usually in this respect over-capitalized. The return on the investment is going to be below it ought to be, & long-term funds will be unnecessarily tide up when they might be invested elsewhere to generate income.
Over capitalization with respect to working capital should never exist when there is good management but the warning since excessive working capital is poor accounting ratios. The ratios which could assist in judging whether or not the investment linrmw working capital is reasonable include the following.
Sales /working capital. The volume of sales being a multiple in the working capital investment should indicate weather, when compared with previous year or with a similar companies, the entire value of working capital is simply too high.
Liquidity ratios. A current ratio more than 2:1 or even a quick ratio greater than 1:1 may indicate over-investment in working capital. Turnover periods. Excessive turnover periods for stocks & debtors, or perhaps a short duration of credit obtained from supplies, might indicate the level of stocks of debtors is unnecessarily high or even the level of creditors too low.