What is working Capital? In a business it can be explained 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, temporary loans, long term debts maturing within twelve months & so on.
Every business needs adequate liquid resources to keep up everyday cashflow. It deserves enough to cover wages & salaries since they fall due & enough to pay for creditors if it is 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 guarantee the survival of the business in the long term as well. Also a profitable company may fail when it does not have adequate income to meet 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 reduce the chance of insolvency as well as the requirement to optimize the return on assets .An excessively conservative approach causing high levels 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 depends on the nature from the company business. For example, a manufacturing company may require more stocks than company in a service industry. Because the volume of output by a company increases, the amount of current assets required will even increase.
Even assuming efficient stock holdings, debt collection procedures & cash management, there exists still a specific level of choice inside the total amount of current assets required to meet output requirement. Policies of low stock-holding levels, tight credit & minimum cash holding might 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 you can find excessive stocks debtors & cash & very few creditors there may an over investment through the company in current assets. It will likely be excessive & the business are usually in this respect over-capitalized. The return on the investment is going to be lower than it should be, & long lasting funds is going to be unnecessarily tide up when they could be invested elsewhere to generate income.
Over capitalization with respect to working capital should never exist when there is good management however the warning since excessive working capital is poor accounting ratios. The ratios which could aid in judging if 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, in comparison with previous year or with similar companies, the total worth of working capital is simply too high.
Liquidity ratios. A current ratio more 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 a short period of credit obtained from supplies, might indicate that this amount of stocks of debtors is unnecessarily high or perhaps the volume of creditors too low.