Determinants of Working Capital
The level of working capital is influenced by many factors. They are:
- Nature of Business
This is one of the main factors. Usually in trading businesses the working capital needs are higher as most of their investment is concentrated in stock or inventory. Manufacturing businesses also need a good amount of working capital to meet their production requirements. Whereas, those companies that sell services and not goods, on a cash basis require least working capital because there is no requirement on their part to maintain heavy inventories.
- Size of Business
Size of business is another influencing factor. As size increases, the working capital requirement is also more and vice versa.
- Credit Terms / Credit Policy
Credit terms greatly influence working capital needs. If terms are:
- buy on credit and sell by cash, working capital is lower
- buy on credit and sell on credit, working capital is medium
- buy on cash and sell on cash, working capital is medium
- buy on cash and sell on credit, working capital is higher.
Prevailing trade practices and changing economic condition do generally exert greater influence on the credit policy of concern.
- A liberal credit policy if adopted more trade debtors would result and when the same is tightened, size of debtors gets slim.
- Credit periods also influence the size and composition of working capital. When longer credit period is allowed to debtors as against the one extended to the firm by its creditors, more working capital is needed and vice versa.
- Collection policy is another influencing factor. A stringent collection policy might not only deter away some credit customers, but also force the existing customers to be prompt in settling dues resulting in lower level of working capital. The opposite holds well with a liberal collection policy.
- Collection procedure also influences the working capital needs. A decentralized collection of dues from customers and centralized payments to suppliers shall reduce the size of working capital. Centralized collections and centralized payments would lead to moderate level of working capital. But with centralized collections and decentralized payments, the working capital need would be the highest.
- Seasonality of Production
Agriculture and food processing and preservation industries have a seasonal production. During seasons, when production activities are in their peak, working capital need is high.
- Seasonality in supply of raw materials
This also affects the size of working capital. Industries that use raw materials which are available during seasons only, have to buy and stock those raw materials. They cannot afford to buy these items in a phased way, since either supplies would get reduced or prices would be higher. Also, from the point of view of quality of raw materials, it pays to buy in bulk during the seasons. Hence the high level of working capital needed when season exists for raw materials.
- Seasonality of demand for finished goods
In case of products like umbrella, rain-coats and other seasonal items, the demand is high during peak seasons. But the production of these items has to be continuous throughout the year to meet the high demand during peak seasons. Thus, working capital requirement would be higher.
- Seasonality of Production
- Trade Cycle
Trade cycle refers to the periodic turns in business opportunities from extremely peak levels, via a slackening to extremely tough levels and from there, via a recovery phase to peak levels, thus completing a business cycle. There are 4 phases of trade cycle.
- Boom Period – more business, more production, more working capital.
- Depression period – less business, less production, less working capital.
- Recession period – slackening business, stock pile-up, more working capital.
- Recovery period – recouping business, stock speedily converts to sales, less working capital.
Under inflationary conditions generally working capital increases, since with rising prices demand reduces resulting in stock pile-up and consequent increase in working capital.
- Production cycle
The time lapse between feeding of raw material into the machine and obtaining the finished goods out from the machine is what is described as the length of manufacturing process. It is otherwise known as conversion time. Longer this time period, higher is the volume and value of work-in-progress and hence higher the requirement of working capital and vice versa.
- System of Production process
If capital intensive, high-technology automated system is adopted for production, more investment in fixed assets and less investment in current assets are involved. Also, the conversion time is likely to be lower, resulting in further drop in the level of working capital. On the other hand, if labor intensive technology is adopted, less investment in fixed assets and more investment in current assets which would lead to higher requirement of working capital.
- Growth and expansion plans
Growth and expansion industries need more working capital than those that are static.
Apart from the above factors, dividend policy, depreciation policy, price level changes, operating efficiency and government regulations also influence the level and the size of working capital.
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