What are the Risks of Excessive Working Capital?

What is a Working Capital?

Both temporary and permanent working capital are necessary to run a business smoothly. Working capital acts as fuel in running business activities. While temporary working capital provides the expenses to meet general day-to-day needs, permanent working capital helps businesses meet larger demands in the future.

As working capital is an unavoidable part of businesses, one may think that having working capital in excess may be a good option for the businesses. Unfortunately, this is not true. While having low working capital is deteriorating, having working capital in excess also has its own perils.

Risks of Having Excessive Working Capital

Some of the risks of having excessive working capital are as follows −

Unnecessary Accumulation of Inventories

Having too much working capital hits the inventories directly. With excessive working capital, too much of inventories are accumulated. This accumulation beyond needs may cause critical damages to the firm holding the inventories. With growing inventories, mishandling the inventories may become rapid. This leads to mismanagement of the inventories.

The management may not be able to stop theft and wastage due to over-accumulation of inventories. This may lead the firm toward increased losses. Firms therefore should avoid the accumulation of inventories due to excessive working capital. One simple solution to this is to invest excess capital into the growth and expansion of the company.

Defective Credit Policy

Excess working capital may be a by-product of a defective credit policy or unnecessarily inactive collection period. While credit policy failure may indicate a dysfunctional credit system, slack in the collection period may create bad debt that ultimately hurts the profitability of the firm. To readjust credit policy failure, the company must re-check the existing working capital and its effects on the firm’s credit system. If it is found to be mismanaged, immediate steps to re-accurate the policy must be enacted.

Negligent Management

When excess working capital arises from mismanagement on the part of the management team of the firm, it degenerates into negligent business policies of the firm. Managerial mismanagement is a serious matter for the firm because if the management fails in finance, the firm’s other departments cannot survive.

Excess working capital accumulation due to faulty management policies is a sign of the deteriorating health of the firm. In order to bring the misalignment onto the track, the management must be made efficient, especially in the finance part of the business firm.

Speculative Profits Growth

Excessive working capital leads to speculative growth of profits beyond the original. This occurs due to speculative growth of inventories which tends to speculative profits growth. It is a sign of severe illness in a firm. As speculative profits go beyond limits it strains the dividend policies of the firm. The firm may need to offer exorbitant dividends that are not possible for it to afford.

Moreover, as the profits do not grow normally, the management may find it tough to contain the speculative growth of profit generally. Therefore, the firm may not bear the excess demands and collapse due to the pressures from the stakeholders.

Conclusion

Businesses should always strive to create a balanced working capital in order to remain intact on the path of holistic profits and growth. Having excessive working capital may harm the businesses fundamentally. The changes that occur due to excess working capital may go beyond the control of the management of a firm.

Therefore, the wise thing to do while working capital seems to go above limits is to check the basics of the business. With efficient handling of working capital, a firm may not only remain in good shape but can also become superbly competitive in its industry.