What exactly 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 like 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 everyday cashflow. It deserves enough to cover wages & salaries because they fall due & enough to cover 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 in the business eventually also. Even a profitable company may fail when it does not have adequate income to fulfill its liabilities since they fall due.
What exactly is Working Capital Management? Ensure that sufficient liquid resources are maintained is dependent on capital management. This involves achieving a balance involving the requirement to reduce the potential risk of insolvency and the requirement to increase the return on assets .An excessively conservative approach causing high levels of cash holding will harm profits because the ability to produce a return on the assets tide as cash will have been missed.
The amount of Current Assets Required. The quantity of current assets required will be based on the nature of the company business. For example, a manufacturing company may need more stocks than company in a service industry. Since the volume of output by way of a company increases, the amount of current assets required will also increase.
Even assuming efficient stock holdings, debt collection procedures & cash management, there exists still a specific amount of choice in the total amount of current assets needed 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 you will find excessive stocks debtors & cash & not many creditors there may an over investment by the company in current assets. It will probably be excessive & the company are usually in this respect over-capitalized. The return on the investment will likely be below it ought to be, & long-term funds will 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 nevertheless the warning since excessive working capital is poor accounting ratios. The ratios which can aid in judging if the investment linrmw working capital is reasonable are the following.
Sales /working capital. The volume of sales as a multiple of the working capital investment should indicate weather, in comparison to previous year or with similar companies, the entire value of working capital is too high.
Liquidity ratios. A current ratio in excess of 2:1 or even a quick ratio more than 1:1 might point to over-investment in working capital. Turnover periods. Excessive turnover periods for stocks & debtors, or even a short duration of credit taken from supplies, might indicate the amount of stocks of debtors is unnecessarily high or the volume of creditors too low.