Working Capital: Objectives, Excess and Inadequacy

Prerequisites

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1. Objectives of Working Capital Management

The primary goal of managing working capital is to maintain an optimal balance between Liquidity and Profitability.

1.1 Key Objectives:

1. Ensuring Liquidity: To ensure that the firm is always able to pay its short-term debts (bills, wages, interest) on time.
2. Optimizing Profitability: To minimize the funds tied up in current assets because idle cash and excess stock earn nothing.
3. Smoothing Operations: To provide enough raw material and cash to prevent production stoppages.
4. Minimizing Risk: To avoid the risk of technical insolvency (being unable to pay debts).

2. Excess Working Capital

Having more working capital than required (over-liquidity) is not ideal. It means the firm has too much idle cash or unused inventory.

2.1 Consequences of Excess Working Capital:

1. Idle Funds: Excess cash in the drawer or bank earns no interest or very low interest, leading to a waste of resources.
2. Low Profitability: Too much capital tied up in stock indicates poor efficiency and reduces the overall Return on Investment (ROI).
3. Risk of Obsolescence: Holding too much inventory increases the risk of stock getting damaged, expired, or going out of fashion.
4. Inefficient Management: It may encourage slackness and poor credit management (allowing customers too long to pay).
5. Speculative Losses: Managers might enter into risky speculative deals because they have "too much cash" on hand.

3. Inadequate Working Capital

Having less working capital than required (under-liquidity) is dangerous and reflects a "hand-to-mouth" existence.

3.1 Consequences of Inadequate Working Capital:

1. Risk of Insolvency: The firm may fail to pay its creditors, leading to legal action or closure.
2. Production Stoppages: Lack of cash to buy raw materials leads to machine idling and loss of sales.
3. Loss of Goodwill: Suppliers will stop trusting the company if payments are always delayed.
4. Missed Opportunities: The firm cannot take large orders or buy bulk materials at a discount because it lacks ready cash.
5. High Interest Costs: The firm might have to take emergency loans at very high interest rates to pay urgent bills.

4. The Trade-off: Risk vs. Profitability

Financial managers face a dilemma:

• More Liquidity = Lower Risk of Insolvency BUT Lower Profitability (due to idle funds).
• Less Liquidity = Higher Profitability (funds used elsewhere) BUT Higher Risk of Insolvency.

The objective is to find the Optimum Working Capital where both liquidity and profitability are balanced.

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Exam Pattern Questions and Answers

Question 1: "Discuss the dangers of inadequate working capital." (5 Marks)

Answer: Inadequate working capital is a serious threat to a firm's survival. The main dangers are:

1. Inability to meet obligations: The firm fails to pay salaries, rent, or suppliers on time, damaging its reputation.
2. Operational Disruptions: Production is halted due to lack of raw materials, leading to lost sales and idle labor costs.
3. Credit Rating Loss: Banks and creditors lose confidence, making it difficult to raise funds in the future.
4. Loss of Cash Discounts: The firm cannot take advantage of discounts offered for prompt payment, increasing its cost of raw materials.
5. Stagnation: The firm cannot modernize its plant or grab new market opportunities because it has no spare cash.

Question 2: "Does excess working capital benefit a firm? Justify." (4 Marks)

Answer: No, excess working capital is not beneficial; it is a sign of inefficiency.

• Waste of Resources: Funds tied up in excess inventory or idle cash earn zero return, lowering the firm's Return on Assets.
• Increased Costs: Higher storage, insurance, and handling costs for excess stock.
• Managerial Slack: Plenty of cash can lead to poor credit control and unnecessary hoarding of stocks.
• Lower Shareholder Wealth: To maximize wealth, every rupee must be put to its most productive use. Excess WC fails this test.

Summary

1. The goal is to maintain Optimum capacity - neither too much nor too little.
2. Excess WC leads to low profitability and waste.
3. Inadequate WC leads to high risk and operational failure.
4. Management must balance the Risk-Profitability Trade-off.

Quiz Time! 🎯

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