Precisely 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 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, temporary loans, long-term debts maturing within twelve months & so on.
All businesses needs adequate liquid resources to keep day to day cashflow. It deserves enough to pay wages & salaries because they fall due & enough to pay for creditors should it be to 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 from the business in the long term too. Even a profitable company may fail when it lacks adequate income to meet its liabilities since they fall due.
Precisely what is Working Capital Management? Ensure that sufficient liquid resources are maintained is a matter of capital management. This involves achieving a balance involving the requirement to minimize the risk of insolvency as well as the requirement to optimize the return on assets .An excessively conservative approach causing high amounts of cash holding will harm profits because the opportunity to create a return on the assets tide as cash may have been missed.
The volume of Current Assets Required. The quantity of current assets required depends on the nature in the company business. For instance, a manufacturing company might require more stocks than company in a service industry. Because the level of output with a company increases, the quantity of current assets required will also increase.
Even assuming efficient stock holdings, debt collection procedures & cash management, there is still a specific amount of choice in the total volume 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 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 from the company in current assets. It will 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 is going to be unnecessarily tide up when they might be invested elsewhere to generate income.
Over capitalization with respect 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 can assist in judging whether the investment linrmw working capital is reasonable range from the following.
Sales /working capital. The volume of sales as a multiple of the working capital investment should indicate weather, in comparison with previous year or with similar companies, the entire price of working capital is just too high.
Liquidity ratios. A current ratio in excess of 2:1 or a quick ratio in excess of 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 volume of stocks of debtors is unnecessarily high or even the volume of creditors too low.