Factors determining the working capital requirement

Factors determining the working capital requirements

The working capital requirements of a concern depend upon a large number of factors such as nature and size of business, the character of their operations, the length of production cycles, the rate of stock turnovers and the state of economic situation. It is not possible to rank them because all such factors are of different importance and the influence of individual factors changes for a firm over time. However the following are the important factors generally influence the working capital requirements:

1. Nature or character of business : The working capital requirements of a firm basically depend upon the nature of it's business. Public utility undertakings like Electricity, water supply and railways need very limited working capital because they offer cash sales only and supply services, not products, and as such no funds are tied up in inventories and receivables. On the other hand trading and financial firm's require less Investment in fixed assets but have to invest a large amount in current assets like inventories, receivables and cash; as such they need large amount of working capital. The manufacturing undertakings also require sizeable working capital along with fixed investments. Generally speaking it may be said that public utility undertakings require small amount of working capital, trading and financial firm's require relatively very large amount, Whereas manufacturing undertakings require sizable working capital between these two extreme.

2. Size of business/Scale of operation : The working capital requirements of a concern is directly influenced by the size of it's business which may be measured in term of scale of operations. Greater the size of a business unit, generally larger will be the requirements of working capital. However, in some cases even a small concerns may need more working capital due to high overhead charges, inefficient use of available resources and other economic disadvantages of small size.

3. Production policy : In certain industries the demand is subject to wide fluctuations due to seasonal variations. The requirements of working capital, in such cases, depend upon the production policy. The production could be kept either stay by accumulating inventories during slack period with a view to meet high demand during the peak season or the production could be curtailed during the slack season and increase during the peak season. If the policy is to keep production steady by accumulating inventories it will require higher working capital.

4. Manufacturing process/ Length of production cycle : In manufacturing business the requirements of working capital  increase in direct proportion to length of manufacturing process. Longer the process period of manufacture, larger is the amount of working capital required. The longer manufacturing time, the raw materials and other supplies have to be carried for a longer period in the process with progressive increment of labour and service costs before the finished product is finally obtained. Therefore, if there are alternative processes of production, the process with the shortest production period should be chosen.

5. Seasonal variations : In certain industries raw material is not available throughout the year. They have to buy raw material in bulk during the season to ensure an uninterrupted flow and process them during the entire year. A huge amount is, thus, blocked in the form of material inventories during such season, which gives rise to more working capital requirements. Generally, during the busy season, a firm requires larger working capital than in the slack season.

6. Working capital cycle : In a manufacturing concerns, the working capital cycle starts with the purchase of raw material and end with the realisation of cash from the sale of finished products. This cycle involves purchase of raw materials and stores, it's conversion into stocks of finished goods through work in progress with progressive increment of labour and service costs, conversion of finished stock into sales, debtors and receivables and ultimately realisation of cash and this cycle continue again from cash to purchase of raw material and so on.

The speed with which the working capital completed one cycle determines the requirements of working capital longer the period of cycle larger is the requirements of working capital.

7. Rate of stock Turnover : There is a high degree of inverse co Relationships between the quantum of working capital and the velocity or speed with which the sales are effected. A firm having a high rate of stock Turnover will need lower amount of working capital as compared to a firm having a low rate of turnover. For example, in case of precious stone  dealer, the turnover is very slow. They have to maintain a large variety of stocks and the movement of stocks is very slow. Thus, the working capital requirements of such a dealer shall be higher than that provision store.

8. Credit policy : The credit policy of a concern on its dealings  with debtors and creditors influenced considerably the requirements of working capital. A concern that purchase it's requirements on credit and sells it's products/services on cash requires lesser amount of working capital. On the other hand a concern buying it's requirements for cash and allowing credit to it's customers, shall need larger amount of working capital as very huge amount of funds are bound to be tied up in debtors or bills receivables.

9. Business cycle : Business cycle refers to alternate expansion and contraction in general business activity. In a period of boom i.e. when the business is prosperous, there is a need for larger amount of working capital due to increase in sales, rise in prices, optimistic expansion of business, etc. On the contrary in the times of depression i.e. when there is a down swing of the cycle, the business contracts, sales decline, difficulties are faced in collections from debtors and firm's may have a large amount of working capital lying idle.

10. Rate of growth of business : The Working capital requirements of a concern increase with the growth and expansion of it's business activities. Although, it is difficult to determine the relationship between the growth in the volume of business and the growth in the working capital of a business, yet it may be concluded that for normal rate of expansion in the volume of business, we may have retained profits to provide for more working capital but in fast growing concerns, we shall require larger amount of working capital.

11. Earning capacity and divided policy : Some firm's have more earning capacity than others due to quality of their products, Monopoly conditions, etc. Such firm's with high earning capacity may generate cash profit from operations and contribute to their working capital. The dividend policy of a concern also influences the requirements of it's working capital. A firm that maintain a steady high rate of cash dividend irrespective of it's generation of it's profits need more working capital than the firm that retains larger part of it's profits and does not pay so high rate of cash dividend.

12. Price level changes : Changes in the price level also affect the working capital requirements. Generally the rising price will require the firm to maintain larger amount of working capital as more funds will be required to maintain the same current assets. The effect of rising price may be different for different firm's. Some firm's may be affected much while some other may not be affected at all by the rise in prices.

13. Other factors : some other factors such as operating efficiency, management ability, irregularities of supply, import policy, assets structure, importance of labour, banking facilities, etc  also influences the requirements of working capital.