How does the need or realisation to maintain Working Capital arise? What is the need of maintaining a balance between the cash in hand for daily transactions and savings/investments?
Let’s understand what actually working capital is. Working capital is that financial metric which represents operating liquidity. Liquidity is a measure which checks the ability of a debtor, i.e. within how many days a debtor is making payment of his outstanding debt as and when they fall due. Plant & Equipment, Land & Building, etc. are considered to be fixed assets, whereas working capital is the operational capital.
Working capital can be calculated as the difference between the total current assets and total current liabilities.
What are current assets now...?
Current assets are basically cash or those assets which can be converted into cash easily within a year.
Examples would be: cash in hand, cash at bank, inventory in hand, accounts receivable.
Now coming to current liabilities…
Current liabilities are those liabilities for which the amount payable term is within a year.
Examples would be: Accounts Payables, dividend payables to shareholders, etc.
Now how does the need or realisation to maintain to working capital arise?
Just imagine, a company has made very good sales in a year…but all are in credit and the company has managed to collect only 40%...or the major part has been invested into long term investments.... now with a limited amount in hand…will the company be able to meet all its dues…like wages and salaries to labourers and employees, rent and electricity bills. With these dues and limited funds in hand how far a company can go…?
Hardly few years….and what if the company has kept all the cash in hand…? It would definitely be able to meet all the dues but… will be missing all the profitable and potential investments.
Hence there is a need to maintain a balance between the two which we call as Profitability and Liquidity so that the company has maintain enough funds to pay off the dues and along with it, is able to catch the opportunity of making profits and the profitable and potential investments.
What is working capital cycle…?
We have already seen working capital, working capital cycle means that the time taken by a company to turn the net current assets and current liabilities into cash. The longer the cycle, the more the company is tying up it’s capital into working capital on which it is not earning any returns…
Companies sometimes try to collect it outstanding debts quicker or extend its payable days to reduce the working capital cycle. A positive working capital cycle balances the inflow and outflow of cash to minimize the working capital holding cost and maximise free cash flow. But maintaining a positive or negative working capital cycle depends from company and sector in which it is conducting its business.
For example: A supermarket or a departmental store may have negative cash flow since all the business is done on cash and not on credit on the same hand it may pay to the suppliers after 45 or 60 days.
Whereas a construction company make have a high and positive operating cycle since they would be paying their workers and for materials, but they would receive the money after the completion or on a certain % of completion.
Hence just looking at the operating cycle we may not be able to conclude or even predict about a company’s ability, we would also be required to know what type of business they are into. Also we can’t compare the operating cycle of a supermarket with that of a construction company as their operations are different.
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