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 one year, & may include amounts owned to trade creditors, taxation payable, dividend payments due, short term loans, long term debts maturing within twelve months & so on.
Every business needs adequate liquid resources to maintain day to day cash flow. It deserves enough to pay wages & salaries as they fall due & enough to pay for creditors should it be to help keep its workforce & ensure its supplies. Maintaining adequate working working capital is not just important in the short term. Sufficient liquidity has to be maintained to make sure the survival in the business in the long term also. Also a profitable company may fail if this lacks adequate income to satisfy its liabilities because they fall due.
Precisely what is Working Capital Management? Make sure that sufficient liquid resources are maintained is dependent on capital management. This requires achieving a balance involving the requirement to minimize the potential risk 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 quantity of Current Assets Required. The volume of current assets required will depend on the nature in the company business. For instance, a manufacturing company may need more stocks than company in a service industry. Because the amount of output by way of a company increases, the volume of current assets required will also increase.
Even assuming efficient stock holdings, debt collection procedures & cash management, there is certainly still a certain amount of choice within the total amount 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 there are excessive stocks debtors & cash & very few creditors there will probably an over investment through the company in current assets. It will likely be excessive & the organization are usually in this respect over-capitalized. The return on the investment will likely be lower than it should be, & long lasting funds will likely be unnecessarily tide up when they might be invested elsewhere to generate income.
Over capitalization regarding working capital should never exist if there is good management nevertheless the warning since excessive working capital is poor accounting ratios. The ratios which could help in judging if the investment linrmw working capital is reasonable are the following.
Sales /working capital. The amount of sales being a multiple from the working capital investment should indicate weather, when compared with previous year or with a similar companies, the total value of working capital is just too high.
Liquidity ratios. A current ratio greater than 2:1 or perhaps 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 period of credit taken from supplies, might indicate that the volume of stocks of debtors is unnecessarily high or the volume of creditors too low.