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 one year & so on.
All businesses needs adequate liquid resources to keep up everyday cashflow. It deserves enough to pay for wages & salaries as they fall due & enough to pay creditors when it is to maintain its workforce & ensure its supplies. Maintaining adequate working working capital is not just important for the short term. Sufficient liquidity should be maintained to guarantee the survival in the business in the long term too. Also a profitable company may fail if this lacks adequate income to satisfy its liabilities because they fall due.
What exactly is Working Capital Management? Make certain that sufficient liquid resources are maintained is dependent on capital management. This requires achieving a balance in between the requirement to minimize the chance of insolvency and the requirement to maximize the return on assets .An excessively conservative approach causing high amounts of cash holding will harm profits because the ability to create 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. As an example, a manufacturing company might require more stocks than company in a service industry. As the amount 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 particular amount of choice inside the total volume 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 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 will an over investment from the company in current assets. It will probably be excessive & the company will be in this respect over-capitalized. The return on the investment is going to be lower than it ought to be, & long term funds will be unnecessarily tide up when they might be invested elsewhere to earn profits.
Over capitalization with respect to working capital must not exist when there is good management however the warning since excessive working capital is poor accounting ratios. The ratios which may help in judging if the investment linrmw working capital is reasonable range from the following.
Sales /working capital. The quantity of sales as a multiple from the working capital investment should indicate weather, when compared with previous year or with similar companies, the complete value of working capital is simply too high.
Liquidity ratios. A current ratio more than 2:1 or perhaps 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 period of credit taken from supplies, might indicate that this level of stocks of debtors is unnecessarily high or the amount of creditors too low.