Factors Determining Working Capital Requirement

Various factors influence the requirement of working capital. The majority of activities of the company affect the company’s working capital requirements. The magnitude of influence may be different. Some important factors determining working capital requirement 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 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 throughout the year can smoothen the fluctuation of the working capital requirement.

Factors Determining Working Capital RequirementCompetition

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. Higher the time, higher would be the time of blocking funds in the working capital.

Credit Policy

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 grows 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.

Factor Deteremine Working Capital Requirement

Taxes

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.

Dividend Policy

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.

Price Levels

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.

Must read Methods for Estimating Working Capital Requirement

Quiz on Factors Determining Working Capital Requirement

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Sanjay Borad

Sanjay Bulaki Borad

Sanjay Borad is the founder & CEO of eFinanceManagement. He is passionate about keeping and making things simple and easy. Running this blog since 2009 and trying to explain "Financial Management Concepts in Layman's Terms".

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