Question

• What are 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

Business may not want to hold too much of working capital or too little of working capital because business should always be holding adequate amount of working capital which will be suiting its needs in order to maximize its overall rate of return and the goal of the working capital is always to maintain adequate cash flows in order to maximize the rate of return of the company.

company should not be holding higher level of working capital because it will mean that the company is having a higher amount of cash in its hands and it does not have proper project in its hands to deploy those cash so that will be meaning that company is losing a lot of opportunity cost and it is losing a lot of investment so the company does not have a growing perspective in the long run.

For example, if the company will be having a lot of cash in its hands then it will be losing on the value of the cash through the time value of the money concept as there will be no appropriate investment so the company will be holding on to higher cash and if those cash would have been invested then there would have been a higher rate of return from investment.

if the company is having lower amount of working capital in its hands then the working capital will not be adequate to meet with the liquidity requirement and the company will be having lower liquidity and Company can be having financial distress cost,as l it will not be able to deal with the interest cost.

Example could be when a company does not have higher amount of cash earning to manage with the interest as seen in the case of distress companies.

So it is always appropriate to maintain adequate amount of cash flows.