okay excellent now that we know what
working capital is and why companies need sufficient working capital to carry
out their core business operations we will use this lesson to dig deeper and
explain the trade off businesses face when they try to optimize their working
capital there have been many businesses some quite profitable that have closed
shop due to bad working capital management see the issue is that
sometimes if working capital is too thin we can have liquidity problems and
cannot repay creditors and trade counterparties so a firm’s working
capital provides sufficient cushion in terms of liquidity too big of a cushion
would mean we’ve invested too much in working capital and we are being
inefficient as this is money that could have been invested elsewhere the money
could have been used to reap a financial liabilities invest in a new capex
project or it could have been redistributed to shareholders so we have
two conflicting goals liquidity and profitability a high investment in
working capital improves liquidity and decreases profitability the level of
working capital of firm maintains isn’t entirely up to its full control because
it depends on negotiations with external parties such as clients and suppliers
with current production capabilities but finance managers must make sure that two
extreme situations will be avoided one is called over trading and represents a
firm that has insufficient working capital to maintain its current level of
sales this is when our working capital is too thin and current liabilities have
grown higher the current assets a disaster in terms of liquidity the
opposite case is called over capitalisation it consists of
maintaining an excessive level of working capital
and missing other investment opportunities given that our cash is not
used and remains blocked in the business and to make things even more delicate we
must know that when some aspects related to working capital items change others
will be affected too so if we offer customers a discount if they paid us
earlier we could increase our cash position as many people who owe us money
will pay us earlier and take us up on the offer however this will likely
reduce our profit margin and will entice these customers to order other products
from us which will decrease our inventory the overall effect will be
that will reduce our receivables decrease profit margins improve our cash
position and decrease inventories see working capital items are interrelated
so we must consider how the change of one parameter affects the others okay
great in the next several lessons we will
focus on the way we typically predict trade receivables inventory and trade
payables this will do for now thanks for watching