Working capital — OpenTuition Forums

Aaccastudent7y ago

Hello sir, over capitalisation leads to WC being too high and over trading leads to WC being too low.. i didn't understand what is high and low WC.. in the example on pg 21 ..in the lecture you explain with the short fall of 100 in WC due to over capitalisation . And the company has to take overdraft of 100. So ..is it so that short fall of cash balance in WC means WC is too high in over capitalisation and Short fall of cash balance due to overtrading means WC is too low ? It would be helpful if you can give an example of WC being too low due to overtrading Thanks alot

John MoffatTutor7y ago#1

I think you would agree that if a company gets a lot bigger, then they need more working capital (more inventory, more receivables). The problem with overtrading is that if that get a lot bigger very quickly then they suddenly need more inventory and suddenly find that they have a lot more receivables. The finance for this has to come from somewhere, and if they haven't planned ahead and already raised more long-term finance then they are forced to take immediate short-term finance (i.e. an overdraft). Overdrafts are not necessarily always a bad thing, if it is part of a plan. But if it happens almost by accident (because they hadn't planned ahead) then it can lead to big problems - a liquidity problem - because the bank might limit the amount they can be overdrawn or even demand that they repay the overdraft (when they can't afford to).

Aaccastudent7y ago#2

Thanks

Aaccastudent7y ago#3

I Understood the concept of liquidity issues due to over trading .. just do not understand what is high and low WC ..is it related to the total amount of WC..i.e. Recvb + invnt - paybl = $100 (this is low while in the other company with same type of business, WC is $600..this is high ?) While the efficient level is 300. Or is it related to the availability of cash ..like if $200 O/D is required , it is high WC and if only $20 o/d is required then this is low WC )

John MoffatTutor7y ago#4

There is no 'formula' that determines whether working capital is high or low. It depends on the type of business and the size of the business. In the example I use to illustrate this in my free lecture, I state that it has been decided that the current level of working capital is reasonable for the type of business. Therefore, if the business becomes twice as big, you would expect them to need twice as much working capital. Again, if they don't raise more long-term finance for the extra working capital then they will be forced into an overdraft position and risk having liquidity problems. It is this that is the potential problem that occurs with over-trading - not the level of working capital.