Determining Working Capital Requirements

The following points highlight the twelve major factors determining working capital requirements. The factors are: 1. Nature of Business 2. Size of Business 3. Manufacturing Cycle 4. Production Policy 5. Business Cycles 6. Conditions of Supply of Raw Material 7. Terms of Credit to Customers 8. Credit from Suppliers 9. Stock Turnover Ratio 10. Price Level Changes 11. Income Tax 12. Operating Efficiency.

1. Nature of Business:

The working capital requirements are significantly influenced by the nature of the business carried on by the firm. Public utility undertakings like road-transport corporations or electricity supply undertakings need very small working capital because they offer services rather than products and offer mostly cash sales with the result that very small amount of capital remains invested in inventory and receivables.

In manufacturing enterprises, the working capital requirements are fairly large. The requirements differ from industry to industry. For example, the working capital requirements of an edible oil mill or a building construction company will be more that those of an iron and steel mill.

The working capital requirements of trading and financial enterprises are the maximum as they have to maintain a sufficiently large amount of cash, inventories and receivables.

2.Size of Business:

Larger the size of business, the greater will be the working capital requirements of the firm as more funds will be looked up in inventories and receivables to meet the demands of bigger size of business.

3.Manufacturing Cycle:

Manufacturing cycle refers to the time-span between the purchase of raw- materials and their conversion into finished goods by means of manufacturing process. Funds remain tied up in semi-finished goods during the manufacturing process.

Longer the manufacturing cycle the larger the working capital needed and vice versa. For example, a distillery requires heavy investment in inventories because it has an ageing process. On the other hand, in a bakery, raw materials are soon . converted into finished goods and not much funds are looked up inventories.

4.Production Policy:

In certain industries, there are wide seasonal changes in demand for the product manufactured by the firm. In such a case, if the firm adopts a steady production policy, inventories of finished goods will accumulate during the off-season periods requiring a higher amount of working capital.

If the firm opts to vary its production schedules in accordance with changing demand, there may be serious production problems. During the slack season, the firm will have to maintain its working force and fixed assets without adequate production and sale.

During the peak period, it will have to operate at full capacity. This arrangement may be a costly affair. One namely is to manufacture some other product during the off-season and concentrate on the main line during the season of the main product. But it may not be feasible in all the cases.

5.Business Cycles:

There are business cycles resulting in marked variations in business conditions. There is an upward swing of business conditions leading to a boom when the business activities are at their peak. It is followed by a downward phase called recession when business activities decline.

The downward phase ends in a depression, completing the business cycle. Then again, there is a recovery to start a new business cycle. During the recovery, the working capital requirements increase while during the stock period, the working capital requirements decrease.

6.Conditions of Supply of Raw Material:

In an industry where raw material is available only in a particular season and the firm has to buy raw material in bulk in that reason to enoure uninterrupted production of finished goods, the working capital requirements will be more. When in cases where the supply of raw material is unpredictable, the firm may have to accumulate stock of raw material requiring more working capital.

7.Terms of Credit to Customers:

The terms of credit granted to customers normally depend upon the norms followed in the industry in which the firm is engages. But the firm has some flexibility within the norms. Ideally, the firm should be use discretion in granting credit to its customers.

Different terms of credit should be offered to different types of customers. A liberal credit policy without caring much for the creditworthiness of the customers will land the firm in trouble and the requirements of working capital will also unnecessarily increase.

8.Credit from Suppliers:

If the firm is able to procure liberal terms of credit from suppliers of raw material, its net working capital requirements will be reduced.

9.Stock Turnover Ratio:

Stock turnover ratio refers to the speed with which finished goods are converted into sales. If a firm has a high stock turnover ratio as in the case of a bakery, its working capital requirements will be less. On the other hand, if a firm has a low stock turnover ratio as in the case of fancy jewellery shop, its working capital requirements will be high.

10.Price Level Changes:

Price level changes also affect the working capital requirements. In times of rising prices, a firm will require a larger amount of working capital to maintain the same quantity of inventory and credit sales. But the effect will be different for different firms. If the firm increases the price of its products promptly, the requirements of working capital will not be high.

11.Income Tax:

Out of the profits, income tax has to be paid. Mostly, advance payment of income- tax has to be made on the estimated income of the current year. The management has no discretion in the matter. If level of income-tax is increased by the government, the working capital requirement will increase.

12.Operating Efficiency:

The working capital requirement can be reduced by management by means of operating efficiency. Management can ensure the efficient utilisation of resources by minimizing wastages, improving coordination’s and accelerating the pace of cash cycle.