The key reasons why a business may not want to hold too much or too little working capital
User Rating: 0 / 5
- Details
- Hits: 2610
The key reasons why a business may not want to hold too much or too little working capital
The working capital of a business indicates the financial ability and how management is efficient. The ratio of working capital measures liquidity, and together with the current percentage, it gauges the capability to take care of short-term obligations. The key reasons why a business may not want to hold too much or too little working capital are three reasons. The first one is transaction needs, which are costs payable constantly in a systematic manner. That is the money that the business pay frequently to buy goods and services and is always predictable. The second reason for holding working capital is for precautionary reasons to meet cash payments, which are unexpected in the future. That also helps to get finances for use when there are unforeseen fluctuations in the inflows. The third one is speculative reasons, which give the firm opportunity to bargain when purchasing goods. The amount of working capital depends on nature as well as the activities of the business. When it involves services that need less cash payment, it will require little working capital. If the firm holds too much cash, the funds will lie idle and earn no return (Preve & Sarria, 2010).
Examples that illustrate the consequences of either situation
The consequence of holding too much working capital is that funds will lie idle, generate no profit for the business, and the rate of return on investments is low. Too much capital results in unnecessary purchases, inventories accumulate, loss and theft as well as waste. There will be defective credit policy and excessive debtors causing more incidences of bad debts resulting in overall inefficiency of the business (Dharmendra, 2015).
The consequence of holding too little working capital is that it becomes difficult to pay the bills, which may result in the closure of the business. The business may end up losing most of the suppliers because they may stop supplying the items needed in the enterprise if the payment is always late. There is late delivery of orders to customers because of a lack of working capital delay production as well as delivery of products and services. When competitors make timely delivery of orders, consumers will have other alternatives and leave your business for good (Dharmendra, 2015).