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2 INTRODUCTION :
INTRODUCTION One of the most important areas in the day to day management of the firm is the management of working capital. Working capital refers to the funds held in current assets. Current assets are essential to use fixed assets. The requirements for current assets are usually greater than the amount of funds available through current liabilities.
5 OPTIMUM INVESTMENT :
OPTIMUM INVESTMENT The importance of adequate working capital can never be over emphasized. A firm has to be very careful in estimating its working capital. The effective management of working capital is the primary means of achieving the firms goal of adequate liquidity. A very big amount of working capital would mean that the firm has idle funds. This results in over capitalization. Over capitalization implies that the firm has too large funds for its requirements, resulting in a low rate of return, ie., profitability will be reduced. If the firm has inadequate working capital, it is said to be under capitalized. Such a firm runs the risk of insolvency. Shortage of working capital may lead to a situation where the firm may not be able to meet its liabilities. Hence it is very essential to estimate the requirements of working capital carefully and determine the optimum level of investment in it. At the optimum level of working capital the profitability will be maximum.
OPTIMUM WORKING CAPITAL Current ratio has traditionally been considered the best indicator of the working capital situation. It is considered that a current ratio of 2 for a manufacturing firm implies that the firm has an optimum account of working capital. Optimum working capital can be determined only with reference to the particular circumstances of a specific situation. In a firm where the inventories are easily saleable and the sundry debtors are as good as liquid cash, the current ratio may be lower than 2 and yet firm may be sound. An optimum working capital ratio dependent upon the business situation as such, and the nature and composition of various current assets.
through government agencies etc., it is essential to keep larger stocks increasing working capital requirements.
dividend utilizes cash, while retaining profits acts as a source of working capital. Thus dividend policies affect working capital.
7.2.13 Approaches :
Approaches 1. Matching or Hedging approach: When the firm uses long term sources to finance fixed assets and permanent current assets, and short term financing to finance temporary current assets. 2. Conservative approach: Under this approach a firm finances its permanent assets and also a part of temporary current assets with long term financing. It relies heavily on long term financing and is less risky so far as solvency is concerned, however, the funds may be invested in such instruments, which fetch small returns to build up liquidity. This adversely affects profitability. 3. Aggressive Approach: The firm uses more short term financing than what is justified, in this approach. The firm finances a part of its permanent current assets with short term financing. This is more risky but may add to the return on assets.