Traditional manufacturing industries require significant working capital investment in inventory (comprising raw materials, work in progress and finished goods) and trade receivables (as their business customers expect to be offered generous credit terms).The level of a firm’s current ratio is heavily influenced by the nature if its business for example: On the other hand a very high current ratio is not to be encouraged as it may indicate inefficient use of resources (for example, excessive cash balances). Even if the current ratio is above 1 this does not guarantee liquidity, particularly if inventory is slow moving. If the current ratio falls below 1 this may indicate problems in meeting obligations as they fall due. Therefore, when determining the appropriate level of working capital there is a trade-off between liquidity and profitability: Hence, a company with a high level of working capital may fail to achieve the return on capital employed (Operating profit ÷ (Total equity and long-term liabilities)) expected by its investors. Funds tied up in working capital tend to earn little, or no, return. The other key objective is profitability. Non-payment (default) can lead to the compulsory liquidation of assets to repay creditors. Late payments can result in lost employee loyalty, lost supplier discounts and a damaged credit rating. A business with insufficient working capital will be unable to meet obligations as they fall due, leading to late payments to employees, suppliers and other providers of credit. One of the two key objectives of working capital management is to ensure liquidity. failure to control working capital, and hence to manage liquidity, is a major cause of corporate collapse.shareholder wealth is more closely related to cash generation than accounting profits.current assets comprise the majority of the total assets of some companies.Working capital management is central to the effective management of a business because: Interest on the overdraft may even exceed the profit arising from the additional sales, particularly if there is also an increase in the incidence of bad debts. However, the company’s cash position will fall due to the longer wait for customers to pay, potentially leading to the need for a bank overdraft. For example, extending the credit period offered to customers can lead to additional sales. Working capital management requires great care due to potential interactions between its components.
Successful management of working capital is essential to remaining in business. Many businesses that appear profitable are forced to cease trading due to an inability to meet short-term obligations when they fall due. It is defined as current assets less current liabilities and, in exam questions, the components are usually inventory and trade receivables, trade payables and bank overdraft. Working capital represents the net current assets available for day-to-day operating activities.
It is, however, essential to study the whole syllabus and not only the specific areas covered in this article. Working capital management is a core area of the syllabus and can form part, or the whole of, a 20-mark question in the exam, as well as being examined by objective test questions.
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