Disadvantages of Excessive and Inadequate Working Capital | Financial Analysis (2024)

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Disadvantages of Excessive and Inadequate Working Capital | Financial Analysis? ›

When there is a redundant working capital, it may lead to unnecessary purchasing and accumulation of inventories causing more chances of theft, waste and losses. ADVERTIsem*nTS: 3. Excessive working capital implies excessive debtors and defective credit policy which may cause higher incidence of bad debts.

(i) Excessive Working Capital leads to unnecessary accumulation of raw materials, components and spares. (ii) Excessive Working Capital results in locking up of excess Working Capital. (iii) It creates bad debts, reduces collection periods, etc. (iv) It leads to reduce the profits.

The most significant disadvantage of this capital is that all surplus working capital held by a company earns no interest, making it zero return capital. Capital has an opportunity cost, and if a corporation has locked too much capital into working capital, it's not making a sensible financial move.

If a company can maintain a low level of working capital without incurring too much liquidity risk, then this level is beneficial to a company's daily operations and long-term capital investments. Less working capital can lead to more efficient operations and more funds available for long-term undertakings.

One of the main causes of working capital shortages is inadequate cash flow. Cash flow is the amount of money that flows in and out of a business over a period of time. It can be affected by various factors, such as sales volume, payment terms, inventory levels, expenses, and credit policies.

A company's working capital ratio can be too high in that an excessively high ratio might indicate operational inefficiency. A high ratio can mean a company is leaving a large amount of assets sit idle, instead of investing those assets to grow and expand its business.

If a company has sufficient working capital, it can continue to pay its employees, and suppliers, pay taxes, and other expenses, even if there are some cash flow challenges. It helps to improve the creditworthiness of the business, have better bargaining power with suppliers, and improve profitability.

What happens if a business doesn t have enough working capital? ›

Without enough working capital, a company may not be able to pay its employees, vendors, lenders or make the investments they need to grow their business.

Broadly speaking, the higher a company's working capital is, the more efficiently it functions. High working capital signals that a company is shrewdly managed and also suggests that it harbors the potential for strong growth.

Though it is good to have negative working capital, it is not everyone's cup of tea. Generally, firms who are dealing with cash-only business enjoy high turnover with negative working capital. Such firms don't supply goods on credit and constantly increase their sales.

A key advantage of Negative Working Capital is the ability to invest strategically to fund fast growth. One of the first entrepreneurs to use this strategy was Sam Walton, founder of US retail giant WalMart.

Working capital = current assets – current liabilities

It can be a positive or negative figure. Generally, the larger your working capital balance, the more likely it is that your business can meet its current financial obligations.

As the amount of working capital increases, the liquidity of the business increases. However, since current assets offer low return, with the increase in working capital the profitability of the business falls.

When it comes to working capital loans, they allow you to quickly bridge the gaps in your cash flow or give a cash boost to your business in a time of need. However, it also comes with disadvantages like high interest rates or no repayment plans.