Various factors influence the requirement of working capital. These factors include the majority of activities of the business. The magnitude of the influence of each factor can be different. Some important factors determining working capital requirements are as below:
Factors Influencing Working Capital Management
Nature of the Industry / Business
The management of working capital is completely different from industry to industry. A simple comparison of the service and manufacturing industries can clarify the point. In the service industry, there is no inventory, and therefore, one big component of working capital is already avoided. So, the nature of the industry is a major factor in determining the working capital requirement.
Seasonality of Industry and Production Policy
Businesses are based on seasons, like the manufacturing of ACs, whose demand peaks in summer and dips in winter. The requirement for working capital will be more in summer than winter if produced in the fashion of their demand. The production policy of producing throughout the year can smoothen the fluctuation of the working capital requirement.
If the industry is competitive, quick response to customer needs is compulsory, and therefore a higher level of inventory is maintained. Liberal credit terms are also mandatory with good service to survive in the market. So, the higher the competition, the higher the requirement for working capital.
Production Cycle Time
The production cycle time refers to the time required for converting the raw materials into finished goods. The higher the time, the higher would be the time of blocking funds in the working capital.
A liberal credit policy demands a higher level of working capital, and a tight credit policy reduces it.
Growth and Expansion
Some industries are static, and others are growing. Obviously, a growing industry increases the requirement of working capital also as compared to a static industry.
Shortage of Supply of Raw Materials
If the raw material supply is not smooth for any reason, companies tend to store more raw materials than needed, increasing the requirement for working capital.
Payment of taxes often takes place in advance. This also blocks a part of working capital. Depending on the tax environment of the industry, working capital needs are also affected.
The dividend policy determines the level of retained profits within the business, which is also used for working capital. This is how; dividend policy affects the need for working capital.
The price levels of inventory and other expenses, such as labor rates, etc., increase the working capital requirement. If the company also can increase the price of their finished goods, it reduces this impact.
Other factors that determine or impact the working capital in some or the other way are as follows:
- Cash Requirements
- Volume of Sales
- Terms of Purchase and Sales
- Inventory Turnover
- Current Assets Requirements
- Operation Efficiency
- Change in Technology
- Firm’s Financing policy and Dividend Policy
- Attitude towards Risk
- Raw material Holing period.
- Work In Progress Holding period
- Finished Goods Holding Period.
- Average Collection Period.
- Average Payment Period.
- Working Capital Cycle.
- Safety Stock of Raw Material.
- Cash Balance to be maintained.
Only learning the factors that determine the requirement of working capital does not solve the whole problem of working capital. Management should also estimate the working capital requirement in monetary terms.
Quiz on Factors Determining Working Capital Requirement
This quiz will help you to take a quick test of what you have read here.