Importance of Adequate Working Capital
Management of working capital is an essential task of the finance manager. He has to ensure that the amount of working capital available is neither too large nor too small for its requirements. A large amount of working capital would mean that the company has idle funds. Since funds have a cost, the company has to pay huge amount as interest on such funds that are used to invest in surplus working capital. Another way to look at it is that there is an opportunity cost involved where the company could have invested the surplus funds in long term investments and earned some return on the same. Various studies conducted by the Bureau of Public Enterprises have shown that one
of the reasons for the poor performance of public sector undertakings in our
country has been the large amount of funds locked up in working capital. This
results in over capitalization. Over capitalization implies that a company has too large funds for its requirements, resulting in a low rate of return, a situation which implies a less than optimal use of resources. On the other hand, if the firm has inadequate working capital, such firm runs the risk of insolvency. Paucity of working capital may lead to a situation where the firm
may not be able to meet its liabilities. It may also mean that a company may not be holding enough inventory in order to meet the customers’ demand and hence would lose sales and eventually some reputation as well. An organization, therefore, has to be very careful in estimating its working capital
requirements. Maintaining adequate 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. When businesses make investment decisions, they must not only consider the financial outlay involved with acquiring the new machine or the new building, etc., but must also take account of the additional current assets that are usually required with any expansion of activity. For e.g.:
Increased production leads to holding of additional stocks of raw materials
and work-in-progress.
An increased sale usually means that the level of debtors and the finished
goods inventory requirements will increase.
A general increase in the firm’s scale of operations tends to imply a need for
greater levels of working capital.
A question then arises what is an optimum amount of working capital for a firm? An organization should neither have too high an amount of working capital nor should the same be too low. It is the job of the finance manager to estimate the requirements of working capital carefully and determine the optimum level of investment in working capital.
Optimum Working Capital
If a company’s current assets do not exceed its current liabilities, then it may run into trouble with creditors that want their money quickly. Not being able to meet its short-term obligations, company shall eventually lose its reputation and not many vendors would like to do business with them.
Current ratio (current assets/current liabilities) (along with acid test ratio to supplement it) has traditionally been considered the best indicator of the working capital situation.
It is understood that a current ratio of 2 (two) for a manufacturing firm implies that the firm has an optimum amount of working capital. A higher ratio may indicate inefficient use of funds and a lower ratio would mean liquidity issues as mentioned above. This is supplemented by Quick Ratio or Acid Test Ratio (Quick assets/Current liabilities) which should be at least 1 (one) which would imply that there is a comfortable liquidity position if liquid current assets are equal to current liabilities (where quick assets / liquid current assets refer to current assets less inventory & prepaid expenses).
Bankers, financial institutions, financial analysts, investors and other people interested in financial statements have, for years, considered the current ratio at ‘two’ and the acid test ratio at ‘one’ as indicators of a good working capital situation. As a thumb rule, this may be quite adequate.
However, it should be remembered that optimum working capital can be determined only with reference to the particular circumstances of a specific situation. Thus, in a company where the inventories are easily saleable and the sundry debtors are as good as liquid cash, the current ratio may be lower than 2 and yet firm may be sound or where the nature of finished goods are perishable in nature like a restaurant, then also the organization cannot afford to hold large amount of working capital. On the other hand, an organization dealing in products which take a longer production time, may need a higher amount of working capital.
In nutshell, a firm should have adequate working capital to run its business operations. Both excessive as well as inadequate working capital positions are dangerous.
Reference :- ICAI