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 such as 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.
All businesses needs adequate liquid resources to keep day to day income. 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 in the short term. Sufficient liquidity should be maintained to make sure the survival in the business eventually as well. Also a profitable company may fail if this does not have adequate cash flow to satisfy its liabilities as they fall due.
What exactly is Working Capital Management? Make sure that sufficient liquid resources are maintained is a point of capital management. This requires achieving a balance involving the requirement to lower the potential risk of insolvency as well as the requirement to increase the return on assets .An excessively conservative approach resulting in high degrees of cash holding will harm profits because the chance to produce a return on the assets tide up as cash will have been missed.
The amount of Current Assets Required. The volume of current assets required depends on the nature from the company business. For example, a manufacturing company might require more stocks than company in a service industry. Since the volume of output with a company increases, the volume 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 inside 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 allow 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 will an over investment through 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 lower than it needs to be, & long-term funds is going to be unnecessarily tide up when they may be invested elsewhere to earn profits.
Over capitalization with respect to working capital should never exist if there is good management however the warning since excessive working capital is poor accounting ratios. The ratios which may help in judging whether the investment linrmw working capital is reasonable range from 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 similar companies, the total worth of working capital is too high.
Liquidity ratios. A current ratio in excess of 2:1 or perhaps a quick ratio in excess of 1:1 might point to 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 this level of stocks of debtors is unnecessarily high or even the amount of creditors too low.