FACTORS DETERMINING WORKING CAPITAL REQUIREMENT
The working capital needs of a firm are determined and influenced by various factors. A wide variety of considerations may affect the quantum of working capital required and these considerations may vary from time to time. The working capital needed at one point of time may not be good enough for some other situation. The determination of working capital requirement is a continuous process and must be undertaken on a regular basis in the light of the changing situations. Following are some of the factors which are relevant in determining the working capital needs of the firm:
1. Basic Nature of Business: The working capital requirement is closely related to the nature of the business of the firm. In case of a retail shop or a trading firm, the amount of working capital required is small enough. Most of the transactions are undertaken in cash and the length of the operating cycle is generally small. The trading concerns usually have smaller needs of working capital, however, in certain cases, large inventories of goods may be required and consequently the working capital may be large. In case of financial concerns (engaged in financial business) there may not be stock of goods but these firms do have to maintain sufficient liquidity all the times.
In case of manufacturing concerns, different types of production processes are performed. One unit of raw material introduced in the production schedule may take a long period before it is available as finished goods for sale. Funds are blocked not only in raw materials but also in labor expenses and overheads at every stage of production. The operating cycle is usually a longer one and sales are made generally on credit terms. So, in case of manufacturing concerns, there is a requirement of substantial working capital.
2. Business Cycle Fluctuations: Different phases of business cycle i.e., boom, recession, recovery etc. also affect the working capital requirement. In case of boom conditions, inflationary pressure appears and business activities expand. As a result, the overall need for cash, inventories etc. increases resulting in more and more funds blocked in these current assets. In case of recession period however, there is usually a dullness in business activities and there will be an opposite effect on the level of working capital requirement. There will be a fall in inventories and cash requirement etc.
3. Seasonal Operations: If a firm is operating in goods and services having seasonal fluctuations in demand, then the working capital requirement will also fluctuate with every change. In a cold drink factory, the demand will certainly be higher during summer season and therefore, more working capital is required to maintain higher production, in the form of larger inventories and bigger receivables. On the other hand, if the operations are smooth and even through out the year then the working capital requirement will be constant and will not be affected by the seasonal factors.
4. Market Competitiveness: The market competitiveness has an important bearing on the working capital needs of a firm. In view of the competitive conditions prevailing in the market, the firm may have to offer liberal credit terms to the customers resulting in higher debtors. Even larger inventories may be maintained to serve an order as and when received; otherwise the customer may go to some other supplier. Thus, the working capital tends to be high as a result of greater investment in inventories and receivable. On the other hand, a monopolistic firm may not require larger working capital. It may ask the customers to pay in advance or to wait for some time after placing the order.
5. Credit Policy: The credit policy means the totality of terms and conditions on which goods are sold and purchased. A firm has to interact with two types of credit policies at a time. One, the credit policy of the supplier of raw materials, goods etc., and two, the credit policy relating to credit which it extends to its customers. In both the cases, however, the firm while deciding its credit policy, has to take care of the credit policy of the market. For example, a firm might be purchasing goods and services on credit terms but selling goods only for cash. The working capital requirement of this firm will be lower than that of a firm which is purchasing cash but has to sell on credit basis.
6. Supply Conditions: The time taken by a supplier of raw materials, goods etc. after placing an order, also determines the working capital requirement. If goods are received as soon as or in a short period after placing an order, then the purchaser will not like to maintain a high level of inventory of that good. Otherwise, larger inventories should be kept e.g., in case of imported goods. It is often seen that the shopkeepers may not be keeping stock of all items, but whenever there is a demand, they procure from the wholesaler/producer and supply it to their customers.
Thus, the working capital requirement of a firm is determined by a host of factors. Every consideration is to be weighted relatively to determine the working capital requirement. Further, the determination of working capital requirement is not once a while exercise, rather a continuous review must be made in order to assess the working capital requirement in the changing situation. There are various reasons which may require the review of the working capital requirement e.g., change in credit policy, change in sales volume etc.
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