Determinants of Working Capital

  • Post last modified:21 April 2021
  • Reading time:9 mins read
  • Post category:Finance
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Number of factors has an influence on the size and need of working capital in an organisation. So no definite rule or formula can be prescribed for calculating the amount of working capital. The data of each company should be analysed to determine the amount of working capital. Still the following factors can be broadly said to affect the working capital requirement:

Nature of business

Trading and industrial concerns need more working capital funds. Enterprises engaged in public utility services need less working capital.

For example, if a concern is engaged in electric supply, it will need less current assets, firstly due to the cash nature of the transactions and secondly due to the sale of services.

However, it will invest more in fixed assets. In addition to it, the investment varies concern to concern, depending upon the size of the business, the nature of the product, and the production technique.

Processing Period

Processing Period Time required for keeping the inventory in store is called storage period. The amount of working capital required is in direct proportion to the storage period. Higher the storage period, higher the amount of goods that a firm should keep in store and higher the working capital.

Also, if the processing time is more, then more quantity of goods must be held in store as work-in-progress which leads to higher working capital requirement.

Manual Labour or Automation

Larger working capital will be required in labour intensive industries than in the automated ones. Industries which are automated will need a large proportion of fixed capital.

However to some extent, the decision to use manual labour or machinery rests with the management. Therefore, it is possible in lot of cases to decrease the requirements of working capital and increase investments in fixed assets and vice versa.

Conditions of supply

If the supply of inventory is swift and adequate, less funds will be needed. But, if the supply is unpredictable, more funds will be invested in inventory. Investment in working capital will fluctuate in case of seasonal nature of supply of raw materials, spare parts and stores.

Firm’s credit policy

The credit policy of a firm determines requirement of working capital. A firm following liberal credit policy to all customers requires more funds. On the other hand, the firm adopting strict credit policy will require less amount of working capital.

Firm’s production policy

The production policy of the firm is an important factor to decide the working capital requirement. The manufacturing cycle starts with the purchase and use of raw material and completes with the production of finished goods.

On the other side, the kind of production policy i.e. whether the production policy is uniform production policy or seasonal production policy etc., also has an influence on the working capital decisions.

Larger the manufacturing cycle and uniform production policy, larger will be the requirement of working capital. The working capital requirement will be higher with varying production schedules in accordance with the changing demand.

Availability of credit

The working capital requirements of a firm are also affected by credit terms granted by its creditors. A firm will need less working capital if liberal credit terms are available to it.

Growth and expansion

The need of working capital is increasing with the growth and expansion of an enterprise. It is difficult to precisely determine the relationship between volume of sales and the working capital needs.

The critical fact, however, is that the need for increased working capital funds does not follow growth in business activities but precedes it. It is clear that advance planning is essential for a growing concern.

Profit margin and dividend policy

The quantum of working capital in a firm depends upon its profit margin and dividend policy. A high net profit margin contributes towards the working capital pool.

To the extent the net profit has been earned in cash, it becomes a source of working capital. Also, the distribution of the high proportion of profits in the form of cash dividends results in a drain on cash resources and thus reduces the company’s working capital to that extent.

The working capital position of the firm is strengthened if the management follows a conservative dividend policy and vice versa.

Access to Money Market If any firm has good access to capital market, it can easily raise loan from bank and financial institutions. It therefore results in minimization of need of working capital.

Operating efficiency of the firm Operating efficiency means the best possible utilisation of a firm’s resources at minimum cost. If a firm successfully controls operating cost, it will be able to improve net profit margin which, will, in turn, release greater funds for working capital purposes.

Business fluctuations

Most firms experience variations in demand for their products and services. These businesses fluctuations affect the working capital requirements.

When there is an upward swing in the economy, sales will increase, correspondingly, the firm’s investment in inventories will also increase. Under boom, additional investment in fixed assets may be made by some firms to increase productive capacity.

This will require additional funds. While on the other hand, when there is a decline in economy, sales will come down and consequently the firms try to reduce their short-term borrowings.

Changes in the technology

The technological changes and developments in the area of production can have immediate effects on the need for working capital. If the firm wish to install a new machine in the place of old system, the new system can utilise less expensive raw materials, the inventory needs may be reduced there by working capital needs.

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