Working capital accounting is a fairly important aspect of financial management. And, a good policy is important for the smooth functioning of the business. Simply put, working capital includes all the things you need for the process of production. It involves the capital, the resources required for the process of production, and many other aspects.
Working Capital Explained
- The items that are commonly included in your working capital items are a mix of current assets and current liabilities.
- The assets would include debtors, inventory, cash, and bank accounts, while the liabilities include creditors and short-term loans (if any).
- While the contents of what comprises the working capital of the company may differ from one company to the other, a standard rule of thumb for assumption of the capital includes all the above heads.
- The working capital ratio is the ratio of current assets to current liabilities and is commonly equal to 2:1.
- It is calculated as the difference between the current assets and the current liabilities.
- A well-accepted norm is that the current assets need to be more than the current liabilities. This is because in case the current liabilities mature, the company needs to be in a position to pay them off, without troubling the fixed assets.
- As long as the current assets exceed the current liabilities, these liabilities can be paid of when the time comes.
Types of Working Capital Policies
The policy is basically about how much capital the company should maintain. Should they go in for a zero-risk arrangement, or can they try a bit of daredevilry in their working capital management? Here are the different working capital policies, their advantages and disadvantages.
- Simple and straightforward, this policy works in an arrangement where the current assets of the business are used perfectly to match the current liabilities.
- It is a medium risk proposition and requires a good amount of attention.
- For example, if the creditor is due to be paid 8 months from today, the company will ensure that there is cash to pay the creditor 8 months hence.
- Today the company may or may not keep the cash on hand.
- It does sound risky, but companies opt for this policy because, by keeping as little cash as they can, they can reinvest it in purchasing more goods, more machinery, which will increase production.
- Also, should the sales occur according to the plan, the profit will soar as well.
- Hence, keeping low levels of working capital means that you can employ your funds more productively elsewhere.
- High risk, and often high return, the aggressive working capital policy visualizes the company keep a really low amount of current assets.
- The idea here is very simple. Collect payments on time, leaving no debtors, and invest that amount in the business.
- And, pay the creditors as late as possible. This means that the business uses very little of its own cash, paying the creditors as late as it possibly can.
- It is a high risk arrangement though, because, should your creditor come asking for money, and for some reason, you don't have enough money to pay them off, you might end up having to sell a costly asset to pay off your debt to them.
- And, if this above eventuality seems unpalatable to you, perhaps you would be better off opting for the conservative policy.
- In this policy, you not only match the current assets and the current liabilities, but you also keep a little safety net just in case of any uncertainty.
- Undoubtedly, this is the policy with the lowest risk, but it reduces the money used in increasing the production.