Determination of Working Capital

  • Post last modified:29 March 2021
  • Reading time:7 mins read

Nature of an enterprise

For a firm engaged in manufacturing activity, a sufficiently large amount of funds will be required to carry inventories. Small companies have smaller proportions of cash, receivables, and inventory than large corporations. This difference becomes more marked in large corporations. A public utility concern, for example, mostly employs fixed assets in its operations, while a merchandising department depends generally on inventory and receivables. Generally, public utility concerns that are set up the render public services required a large amount of finished assets, their inventory requirement is usually less. Thus, needs for working capital are determined by the nature of an enterprise.

Size of the business

The size of a business have also an important impact on its capital needs. Size may be measured in terms of operation. A firm with a larger scale of operation will need more working capital than a small firm. The composition of current assets is a function of the size of the business and the industry to which it belongs.

Production policy of the firm

The production policies pursued by the management have a significant effect on the requirements of the working capital of the business. For example, if the management of an enterprise decides to hold inventory worth 3 months production requirement to maintain fairly steady production throughout the year, it will require a large amount of cash to finance the inventory requirements than the one following a hand-to-mouth policy of carrying inventories.

Terms of buying and selling

Terms on which goods are bought and sold decide, to a large extent, the amount of cash reserve that a firm will have to hold. If a business firm can manage to buy materials on credit terms but sells its products in cash, it can run its affairs with a little cash balance. The reserve tendency will be found where the firm makes purchases on a cash basis but it has to sell its products to customers on credit terms. In short, the working capital requirement is also affected by the credit facilities enjoyed by the firm.

Volume of sales

Needs for working capital are mostly determined by the volume of sales. This is the factor, which affects the size of working capital. A firm maintains current assets because they are needed to support the operational activities which result in sales. The volume of sales and the size of working capital are directly related to each other. As the volume of sales and the size of the working capital are directly related to each other. As the volume of sales increases, there is an increase in the investment of working capital.

Manufacturing process (Cycle)

The magnitude of investment in work-in-process is essentially dependent upon the time lag between feeding raw materials in the production process and completing the finished product. The longer the time required for inventories to travel through the various product process, the greater would be fund requirements to carry work-in-process inventory and vice-versa. It is usually observed that the length of the production period is greater where the production process is complex and complicated.

Business cycle

Business expands during the period of prosperity and declines during the period of depression. Consequently, more working capital is required during the period of prosperity and less during the period of depression. Raw materials inventory requirements vary depending on fluctuation in the level of economic activity. Where the management expects expansionary tendency to set at the ensuing months and prices of materials are very likely to shoot up, it would be in the fitness of things to buy the materials in bulk to exploit the forthcoming opportunities.

Supply of raw materials

Need to pile substantially large stock of materials increases the level of investment in raw materials inventory. In the case of specific manufacturing, certain companies have to obtain and maintain a large reserve of raw materials due to their irregular sales and intermittent supply. This is particularly true in case of companies requiring special kind of raw materials has to be kept instore to avoid any possibility of the production process coming to a dead halt.

Profit margin

The net profit is an important source of working capital to the extent it has been earned in cash. Every business house has a different capacity to generate profit from trading operations. Some firms enjoy a dominant position(i.e. known as cash cow position) due to quality product or good marketing management or monopoly power in the market and earn a high-profit margin.

Profit appropriation

Corporate taxes affect the rate of a dividend of the concerns, ultimately its effect on working capital also. Even in net profits are earned in cash at the end of the period, the whole of it is not available for working capital purposes. The contribution towards working capital would be affected by the way in which profits are appropriated. The availability of cash generated from operations thus depends upon taxation dividend and retention policy and depreciation policy.

Growth and Expansion

Another factor which influence the need of working capital in the policy of growth and expansion of the business. If a business concern has ambitious plans for growth and expansion, it requires large amount of working capital, to fulfill such requirements. On the other hand, in case the company has already expanded considerably, it does not require funds for further expansions.

Operating Efficiency

By accelerating the efficiency of production engineers and planners, the length of the production period can be shortened. Consequently, fund requirements to carry investment in work-in-process will decline. A firm, which is engaged in a few processes of production of goods, if contracts with others for other processes, its inventory requirements will be less than what it would have been had the firm engaged in complete production. The operating efficiency of the firm relates to the optimum utilization of resources at minimum cost.

Capital structure of the company

Capital structure of a company refers to the composition of its capitalisation and it includes all long-term capital sources viz. loans, reserves, shares and bonds. If shareholders have provided some funds towards the working capital needs also (at least to satisfy the permanent working capital needs) the management will find it relatively easy to manage working capital. If the company has to-depend entirely upon outside sources for both permanent and temporary working capital needs, it faces an uphill task under dear money conditions.

Price level changes

Generally, rising price levels will require a firm to maintain a higher amount of working capital. Some levels of current assets will need increased investment when prices are increasing. However, the companies which can immediately revise their product prices with rising price levels will not face a severe working capital problem. Further, the effects of increasing general price level will be felt differently by the firms as individual prices may move differently. It is possible that some companies may not be affected by the rising prices while others may be badly hit by it.

Credit policy of R.B.I

The credit policy of R.B.I. is another important factor that influences the requirement of working capital. If the Reserve Bank of India follows selective and restrictive credit policies, the working capital position becomes difficult. Suppliers insist on advance payments, while it will be difficult to sell unless competitive credit terms are offered to the customers. Therefore, before a precise estimate of the working capital needs of the enterprise, the finance manager must be well versed with the variables that influence the magnitude of cash, receivables, and inventories.

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