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 like 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 as they fall due & enough to cover creditors when 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 must be maintained to make sure the survival from the business eventually also. Even a profitable company may fail when it lacks adequate cash flow to meet its liabilities as they fall due.
What exactly is Working Capital Management? Make certain that sufficient liquid resources are maintained is a matter of capital management. This involves achieving a balance between the requirement to reduce the chance of insolvency and also the requirement to optimize the return on assets .An excessively conservative approach leading to high levels of cash holding will harm profits because the ability to produce a return on the assets tide up as cash will have been missed.
The quantity of Current Assets Required. The quantity of current assets required will be based on the nature from the company business. For example, a manufacturing company may need more stocks than company in a service industry. Since the amount of output with a company increases, the amount of current assets required will even increase.
Even assuming efficient stock holdings, debt collection procedures & cash management, there is still a certain degree 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 you can find excessive stocks debtors & cash & very few creditors there may an over investment through the company in current assets. It will probably be excessive & the organization will be in this respect over-capitalized. The return on the investment will be below it needs to be, & long lasting funds will likely be unnecessarily tide up when they may be invested elsewhere to earn profits.
Over capitalization with regards to working capital should never exist if there is good management but the warning since excessive working capital is poor accounting ratios. The ratios which could aid in judging whether or not the investment linrmw working capital is reasonable include the following.
Sales /working capital. The quantity of sales as being a multiple of the working capital investment should indicate weather, in comparison with previous year or with a similar companies, the entire price 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 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 the volume of stocks of debtors is unnecessarily high or perhaps the amount of creditors too low.