Blog

Factors Determining Working Capital

These are the factors determining working capital explained below in detail:

1. Nature of Industry
2. Demand of Industry
3. Cash Requirements
4. Nature of Business
5. Time
6. Volume of Sales
7. Terms of Purchase and Sales
8. Inventory Turnover
9. Receivable Turnover
10. Business Turnover
11. Business Cycle
12. Volume of Current Assets
13. Variation of Sales
14. Production Cycle
15. Credit Controls
16. Liquidity and Profitability
17. Inflation
18. Seasonal Fluctuations
19. Profit Planning and Control
20. Repayable Ability
21. Repayable Ability
22. Operational and Financial Efficiency
23. Changes in Technology
24. Firms Policies
25. Size of Firm
26. Activities of Firm
27. Attitude of Risk

Nature of Industry

The composition of an asset is a function of the size of a business and the industry to which it belongs. Small companies have smaller proportions of cash, receivables, and inventory than large corporations. This difference becomes more marked in large corporations.

A public utility, for example, mostly employs fixed assets in its operations, while merchandising department depends generally on inventory and receivables. Needs for working capital are thus determined by the nature of an enterprise.

Demand of Industry

Creditors are interested in the security of loans. They want their obligations to be sufficiently covered. They want the amount of security in assets which are greater than the liability.

Cash Requirements

Cash is one of the current assets which is essential for successful operations of the production cycle. Cash should be adequate and properly utilized. It would be wasteful to hold excessive cash.

A minimum level of cash is always required to maintain good credit and good credit relations. Richards Osborn has pointed out that cash has universal liquidity and acceptability. Unlike illiquid assets, its value is clear-cut and definite.

Nature of Business

The nature of business is an important determinant of the level of working capital. Working capital requirements depend upon the general nature or type of business. They are relatively low in public utility concerns, in which inventories and receivables are rapidly converted into cash.

Manufacturing organizations, however, face problems of slow turnover of inventories and receivables and invest large amounts in working capital.

Time

The level of working capital depends upon the time required to manufacture goods. If the time is longer, the size of the working capital is greater.

Moreover, the amount of working capital depends upon inventory turnover and the unit cost of the goods that are sold. The greater this cost, the bigger the amount of working capital.

Volume of Sales

This is the most important factor affecting the size and components 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 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 in the cost of operations, inventories, and in receivables.

Terms of Purchase and Sales

If the credit terms of purchase are more favorable and those of sales less liberal, less cash will be invested in inventory. With more favorable credit terms, working capital requirements can be reduced.

A firm gets more time for payment to creditors or suppliers. A firm that enjoys greater credit with banks needs less working capital.

Inventory Turnover

If the inventory turnover is high, the working capital requirements will be low. With better inventory control, a firm is able to reduce its working capital requirements. While attempting this, it should determine the minimum level of stock which it will have to maintain throughout the period of its operations.

Receivable Turnover

It is necessary to have an effective control of receivables. A prompt collection of receivables and good facilities for settling payables result in low working capital requirements.

Business Turnover

The business turnover of the organization directly calls for systematic planning for production. The exploitation of the available business can be achieved only when sufficient raw materials are stored and supplied. Hence Business Turnover will also influence the working capital.

Business Cycle

Business expands during periods of prosperity and declines during the period of depression. Consequently, more working capital is required during periods of prosperity and less during periods of depression.

During marked upswings of activity, there is usually a need for larger amounts of capital to cover the lag between collection and increased sales and to finance purchases of additional materials to support growing business activity.

Volume of Current Assets

A decrease in the real value of current assets as compared to their book value reduces the size of the working capital. If the real value of current assets increases, there is an increase in working capital.

Variation of Sales

A seasonal business requires the maximum amount of working capital for a relatively short period of time.

Production Cycle

The time taken to convert raw materials into finished products is referred to as the production cycle or operating cycle. The longer the production cycle, the greater the requirement for working capital.

The utmost care should be taken to shorten the period of the production cycle in order to minimize working capital requirements.

Credit Controls

Credit Controls include such factors as the volume of credit sales, the terms of credit sales, the collection policy, etc. With a sound credit control policy, it is possible for a firm to improve its cash inflow.

Liquidity and Profitability

If a firm desires to take a greater risk for bigger gains or losses, it reduces the size of its working capital in relation to its sales. If it is interested in improving its liquidity, it increases the level of its working capital.

However, this policy is likely to result in a reduction of the sale volume, and, therefore, of profitability. A firm, therefore, should choose between liquidity and profitability and decide about its working capital requirements accordingly.

Inflation

As a result of inflation, the size of the working capital is increased in order to make it easier for a firm to achieve a better cash inflow. To some extent, this factor may be compensated by the rise in selling price during inflation.

Seasonal Fluctuations

Seasonal Fluctuations in sales affect the level of variable working capital. Often, the demand for products may be of a seasonal nature. Yet inventories have got to be purchased during certain seasons only. The size of the working capital in one period may, therefore, be bigger than that in another.

Profit Planning and Control

The level of working capital is decided by the management in accordance with its policy of profit planning and control. Adequate profit assists in the generation of cash. It makes it possible for the management to plow back a part of its earnings into the business and substantially build up internal financial resources.

A firm has to plan for taxation payments, which are an important part of working capital management. Often dividend policy of a corporation may depend upon the amount of cash available to it.

Repayable Ability

A firm’s repayment ability determines the level of its working capital. The usual practice of a firm is to prepare cash flow projections according to its plans of repayment and to fix working capital levels accordingly.

Repayable Ability

A firm’s repayment ability determines the level of its working capital. The usual practice of a firm is to prepare cash flow projections according to its plans of repayment and to fix working capital levels accordingly.

Operational and Financial Efficiency

Working capital turnover is improved with the better operational and financial efficiency of a firm. With a greater working capital turnover, it may be able to reduce its working capital requirements.

Changes in Technology

Technology developments related to the production-process have a sharp impact on the need for working capital.

Firms Policies

These affect the level of permanent and variable working capital. Changes in credit policy, production policy, etc., are bound to affect the size of working capital.

Size of Firm

A firm’s size, either in terms of its assets or sales, affects its need for working capital. Bigger firms, with many sources of funds, may need less working capital as compared to their total assets or sales.

Activities of Firm

A firm’s stocking on heavy inventory or selling on easy credit terms calls for a higher level of working capital for it than for selling services or making cash sales.

Attitude of Risk

The greater the amount of working capital, the lower the risk of liquidity. Whenever there is a current strain, it has to be immediately diagnosed on the basis of the red signals which manifest themselves in the operation.

The cause should be ascertained by making a thorough study of the components of current assets and current liabilities.

---

FAQs About the Factors Determining Working Capital