Working Capital Management
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.
Every business needs adequate liquid resources to maintain day to day cash flow. It needs enough to pay wages & salaries as they fall due & enough to pay creditors if it is to keep its workforce & ensure its supplies. Maintaining adequate working working capital is not just important in the short term. Sufficient liquidity must be maintained in order to ensure the survival of the business in the long term as well. Even a profitable company may fail if it does not have adequate cash flow to meet its liabilities as they fall due.
What is Working Capital Management?
Ensure that sufficient liquid resources are maintained is a matter of capital management. This involves achieving a balance between the requirement to minimize the risk of insolvency and the requirement to maximize the return on assets .An excessively conservative approach resulting in high levels of cash holding will harm profits because the opportunity to make a return on the assets tide up as cash will have been missed.
The volume of Current Assets Required.
The volume of current assets required will depend on the nature of the company business.
For example, a manufacturing company may require more stocks than company in a service industry. As the volume of output by 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 certain degree of choice in the total volume of current assets required 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 & very few creditors there will an over investment by the company in current assets. It will be excessive & the company will be in this respect over-capitalized. The return on the investment will be lower than it should be, & long term funds will be unnecessarily tide up when they could be invested elsewhere to earn profits.
Over capitalization with respect to working capital should not exist if there is good management but the warning since excessive working capital is poor accounting ratios. The ratios which can assist in judging whether the investment in working capital is reasonable include the following.
• Sales /working capital. The volume of sales as a multiple of the working capital investment should indicate weather, in comparison with previous year or with similar companies, the total value of working capital is too high.
• Liquidity ratios. A current ratio in excess of 2:1 or a quick ratio in excess of 1:1 may indicate over-investment in working capital.
• Turnover periods. Excessive turnover periods for stocks & debtors, or a short period of credit taken from supplies, might indicate that the volume of stocks of debtors is unnecessarily high or the volume of creditors too low.
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Tags: Business, Cash flow, Finance, Financial Services, Investing, Investment, Market liquidity, Working capital