Question

Examine the key reasons why a business may not want to hold too much or too little working capital. Provide examples that illustrate the consequences of either situation.

Answer 1

Working capital is the difference between current assets and current liabilities. Current assets include inventories, cash on hand, cash in bank, which can be converted into cash within a year while current liabilities are those debts that are to be paid within a year. Working capital reflects both the liquidity and operational efficiency of the company.

a) Too high working capital

Advantage- Company has more than sufficient cash or short-term assets in hand to meet the short term liability. It will ensure that company will not have to borrow from external sources and is unlikely to run out of money.

Disadvantage- High WC means a company is leaving a relatively large amount of assets unused for purposes of reinvesting available capital to grow and expand its business. Excessively high WC suggests the company is letting excess cash and other assets just sit idly rather than actively investing its available capital in expanding the company's business. This indicates poor financial management and lost business opportunities.

b) Too little working capital

Advantage- The amount of working capital required each operating cycle is dependent on a company's operating efficiency. For example, the more a company can make in cash sales or the faster it can turn over inventories, the lower the amount of working capital it needs. When a company maintains a low level of working capital, it can force itself to improve its operating efficiency so operating cash flows, coupled with additional working capital, can safely cover costs and expenses during operations. With too much funding tied up idly in working capital for liquidity backup, a company may become less concerned about operating efficiency.

Disadvantage- The only disadvantage is that the company can have liquidity issue. It can simply run out of short term assets to pay the bills. It will hamper company's day to day operations