Having the right amount of working capital is very important for a business. It is also very important that a firm calculates its working capital accurately in order to use its cash flows effectively. There are problems that are bound to arise when a firm holds a lower or a higher capital.
For the case of having too little working capital, a business will be undercapitalized. The business will also likely have cash flow problems and risk collapse of the business. Take for example business A that has a working capital of $25000 and sales of $1000,000. The working capital turnover of this firm is 40 which in this case are little. This firm will face challenges of cash flow problems and will require the usage of credit cards, supplier credit for its survival. In a year the business will have 9 days that can cover its no collection of money. Such a business as analyzed is trying to do too much business with very little working capital.
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When a business has a high working capital the business is said to be overcapitalized. Problems that are likely to rise with a high working capital include inefficient utilization of cash and investment opportunities. The business will also likely to be conservative in the future or in the long run.
Consider the example of business B which has $1000,000 sales and $250,000 of working capital. The working capital turnover will be 4 which is too high or too much. This firm in a year will have approximately 90 days for it to cover for days of no money collection. The cash in the firm is not being used effectively. The business is overcapitalized.
