Impact of Inflation on Working Capital Requirement

The term inflation refers to rise in general (on an average basis) price level of goods and services in the economy, i.e., fall in purchasing power of money. Working Capital is the money used to make goods and attract sales. During the period of rising prices, a firm needs more funds to finance working capital. Hence, it should be planned properly. Not under-standing the impact of inflation on working capital has been the cause of many business failures. Cost of financing the working capital rises because of increase in interest rates. Cash should never be allowed to remain idle (Time eats value of money, i.e., on one hand the company suffers loss of interest and on the other purchasing power of wealth kept as cash declines). Good cash management can provide a major source of profit, while poor cash management can destroy a company in a short time.

When the inflation rate is high, it will have a direct impact on the requirement of working capital as explained below:

  1. Inflation will cause the slow turnover figure at higher level even if there is no increase in the quantity of sale. The higher the sale means the higher level of balance in receivables.
  2. Inflation will result in the increase of raw material price and hike in the payment for expenses and as a result increase in balance of trade creditors and creditors for expense.
  3. Increase in the valuation of closing stock will result in showing higher profits but without its realization into cash cause the firm to pay higher tax dividend and bonus. This will lead the firm in serious problem in fund shortage and the firm may enable to meet its short term and long-term obligation.
  4. Increase in investment in current asset means the increase in the requirement of working capital without corresponding increase in sale or profitability of a firm.

In order to control working capital needs in periods of inflation, the following measures may be applied.

  1. The possibility of using substitute raw materials without affecting quality must be explored in all seriousness. Research activities in this regard may be undertaken, with financial assistance provided by the Government and the corporate sector, if any.
  2. Attempts must be made to increase the productivity of the work force by proper motivational strategies. Before going in for any incentive scheme, the cost involved must be weighed against the benefit to be derived. Though wages in accounting are considered a variable cost, they have tended to become partly fixed in nature due to the influence of various legislative measures adopted by the Central or State Governments. Increased productivity results in an increase in value added and this has the effect of reducing labor cost per unit.

Keeping in view of the above stated points the finance manager should be very careful about the impact of inflation in assessment of working capital requirement and its management.