There are no set rules or formulate to determine the working capital requirements of a firm. The corporate management has to consider the various factors in making decisions regarding working capital balances. An appraisal of these would provide guidance to management in estimating prospective needs. These are called as determinants of working capital.
The firm must estimate its working capital very accurately because excessive working capital results in unnecessary accumulation of inventory and wastage of capital whereas shortage of working capital affects the smooth flow of operating cycle and business fails to meet its commitment.
In this section let us examine the various determinants of working capital.
- Nature of Business is one of the factors. Usually in trading businesses the working capital needs are higher as most of their investment is found concentrated in stock. On the other hand, manufacturing/processing business need a relatively lower compared to that of trading business/level of working capital. The terms of ‘higher’ and ‘lower’ used above are relative and not absolute. That is, of the total capital employed in the businesses a higher or lower, as the case may be, portion is employed in current assets.
- Sales and Demand Conditions of a firm also affect its working capital position. It is difficult to precisely determine the relationship between volume of sales and working capital needs. Sales depend on the demand conditions. Most of the firms experience seasonal and cyclical fluctuations in the demand of their products and services. These business variations affect the working capital requirement, particularly the temporary working capital requirement of the firm. When there is an upward swing in the economy, the sales will increase and untimely the firm’s investment in inventories and debtors will also increase. On the other hand, when there is a decline in the economy, the sales will fall and ultimately, the level of inventories and debtors will also fall. Under recessionary conditions firms try to reduce their short-term borrowings.
- Manufacturing Policy: The manufacturing cycle of the firm also affects the requirement of the working capital. The manufacturing cycle comprises the purchase and use of raw material and production of finished goods. Longer the manufacturing cycle, larger will be the firm’s working capital requirements and vice versa. An extended manufacturing time span means a larger tie-up of funds in inventories. Further, the requirement of working capital also depends on whether the firm has adopted steady production policy or variable production policy.
- Credit Policy: In the present day circumstances, almost all units have to sell goods on credit. The nature of credit policy is an important consideration in deciding the amount of working capital requirement. The larger the volume of credit sales, the greater will be the requirement of working capital. Generally, the credit policy of an individual firm depends on the norms of the industry to which the firm belongs. Credit periods also influence the size and composition of working capital. When longer credit period is allowed to customers as against the one extended to the firm by its suppliers, more working capital is needed and vice versa In the former case, there will be a relatively higher trade debtors and in the latter there will be a higher trade creditors.
- Collection policy is another influencing factor. A stringent collection policy might not only deter away some credit seeking customers, also force existing customers to be prompt in settling dues resulting in lower level of working capital. The opposite is true with a liberal collection policy. Collection procedures do influence the level of working capital. A decentralized collection of dues from customers and centralized payments to suppliers, shall reduce the size of working capital. Centralized collections and centralized payments or decentralized collections and decentralized payments would lead to a moderate level of working capital. But with centralized collections and decentralized payments, the working capital need will be the highest.
- The Availability of Credit from banks and financial institutions also influences the working capital requirement of a firm. The availability of credit to a firm depends upon the creditworthiness of the firm in the money market. If a firm has good credit standing in the market, it can get credit easily on favorable terms and hence it will require less working capital.
- The Operating Efficiency of the firm relates to the optimum utilization of resources at minimum costs. If the firm is efficient in controlling its operating costs and utilizing its current assets, than it helps in keeping the working capital at a lower level. The use of working capital is improved and pace of cash conversion cycle is accelerated with operating efficiency.
- The Price Level Changes also affect the level of working capital. Generally, rising price levels will require a firm to maintain higher amount of working capital. However, the effect of rising prices may be different for different companies, as though the general price level increases, the individual prices may move differently. Therefor some firms may require more working capital, while other may require less working capital in case of price rise.
- Inflation has a bearing on level of 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.
- Level of trading is another factor. There are two levels of trading, viz. over trading and under trading. Over trading means the business wants to maximize turnover with inadequate stock level, hastened production cycle and swiftest collection from debtors. Eventually the working capital will be lower. It is no good, however, for the business is starved of its legitimate working capital needs. Under trading is the opposite of over-trading. There is lethargy and overt lags. There results a higher work-capital. This is no good either, since the working capital is not effectively utilized. It is wastage of capital.
- The Growth and Expansion Plans to be undertaken by a firm also affect its requirements of working capital. Hence the planning of the working capital requirements and its procurements must go hand in hand with the planning of the growth and expansion of the firm. Even the expansion of the sales also increases the requirements of working capital.
- System of production process is another factor that has a bearing. If capital intensive, high technology automated system is adopted for production, more investment in fixed assets and less investment is current asses 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 (especially work-in-progress due to inclusion of an enhanced wage component and prolonged processing) result.
- Dividend policy: A desire to maintain an established dividend policy may affect working capital, often changes in working capital bring about an adjustment of dividend policy. The relationship between dividend policy and working capital is well established and very few companies declare a dividend without giving due consideration to its effects on cash and their needs for cash. A shortage of working capital often acts as a powerful reason for reducing or skipping a cash dividend. On the other hand, a strong position may justify continuing dividend payment.
- Finally rapidity of turnover comes. There is a negative correlation between rapidity of turnover and size of working capital. When sales are fast and swift, lower is the investment in working capital. Actually stock of inventory is very minimum. But, when sales are happening far and in-between, i.e. rather slow, as in the case of jewellery, elaborate investment in working capital results. Thus faster sales lead to lower working capital and vice versa.