Your Financial Analysis Lecture made the statement quoted be

Your Financial Analysis Lecture made the statement quoted below. Assume Simmi Company, a computer hardware manufacturer, has a high working capital because current assets include a high cash balance. (You may select either (1) or (2) below to answer.) (1) How could a firm have too much working capital? Isn\'t working capital a good thing? (2) There may be a number of sound business reasons that Simmi Company has a high cash balance at this point in time. What might that reason be?

Solution

1) Working capital (net) refers to the total of current assets as reduced by the current liabilities. Current assets include mainly cash, inventories and debtors. A firm may carry more cash or inventory or debtors than what is actually required or justified, thereby leading to too much of working capital. While adequate working capital is necessary, too much is harmful, as it will lead to higher financing charges and also losses in realization. Idle cash does not generate earnings. Similarly too much of investment in inventories only increases holding costs and higher investment in receivables will entail higher financing charges and might result in bad debt losses. Hence, though working capital is a good thing, too much is harmful. Higher investment in inventory may be due to carrying higher stocks or may be due to presence of obsolete or non-moving inventory. Higher receivables might be due to granting of higher credit period and/or also poor credit and collection policy.