Determinants of Working Capital

The working capital needs are not uniform for all the enterprise and therefore, facts responsible for a  particular size of current assets in one concern are different from the other enterprise. Therefore, a set pattern of factors determining the size of working capital is difficult to suggest. However, following are some of the most important factors determining the size of the working capital in an enterprise:

1. Nature of Business and Length of Operating Cycle :

A close relationship exists between the nature of the business and the length of the operating cycle, in so much so, the length of the operating cycle is a function of the nature of business. For a vertically integrated manufacturing firm the operating cycle consists of converting cash into raw materials, raw materials into finished goods, selling the product or products through its retailing outlets, and converting the accounts receivables into cash. For an independent retail trade store, the manufacturing portion of the operating cycle is eliminated but the conversion of inventories into receivables, and then into cash remain. For providing those services, the inventory problem is usually eliminated but the collection of receivables remains. Firms selling services on a strictly cash basis may be able to disregard working capital altogether, while cash and carry retail trade outlets eliminate the need to finance receivables.

Where cost of raw materials to be used in manufacturing is very large in proportion to total cost, working capital requirements are bound to be large. For instance, in sugar and, textile mills, raw materials are of prime importance, hence more working capital needed.

The amount of working capital is also affected by the technique of production. In labour intensive industry larger working capital is required than in a highly mechanised one. The latter will have a larger proportion of fixed capital.

2. Management Attitude Towards Risks :

It is generally accepted in principle that greater the risk a management is prepared to undertake, greater  shall be the opportunity for profit or loss to increase. In the area of working capital, management risk implies operating with a lesser amount of current assets than are indicated, by a given level of the firm’s operational activity. Thus, if the management decides to operate with a lesser amount of working capital in relation to its level of production, it is carrying greater risk and there is a greater opportunity for its profit or loss to increase. A mere progressive management may opt for greater risk by keeping its investment very near the optimum level and thus increase the chance of a higher rate of return on their investments.

3. Turn Over :

By turn over is meant the ratio of annual gross sales to average working assets. It is this figure which shows how many times the amount invested in working assets has been treated in or turned over during a year. It must be remembered that the relation is between gross sales and working assets and not between gross sales and working capital. The higher the turn-over the lower the period for which goods remain in the investories. If sales are quick, there will not be much stock held up in the investories. But if the sales are not regular and are uncertain, then the inventory will be in the stock and the amount needed for this will be heavy.

4. Terms of Purchase and Sales :

If an enterprise is paying in cash for everything it is purchasing, and selling it on credit, it will obviously need a working capital sufficient to purchase outright its entire stock of goods including everything that has been sold but not yet paid for. On the other hand, if the enterprise is able to buy on long credit and sell for cash, it can provide for its whole stock with no immediate outlay and will pay its bills as they mature out of the receipts from its own sales. But in ordinary course of time neither of these extreme arrangements prevails. Goods are both bought and sold, atleast in part, on credit basis although the recent tendency is to reduce the length of the credit period. The longer the period for credit, the larger will be the working capital needed to finance the transaction.

5. Cash Requirements :

The greater the cash requirements, higher will be the amount of working capital. If a company has sufficient amount of current assets which can be easily converted into cash or has good banking connections it will not need large cash balances.

6. Seasonal Requirements :

Seasonal industries like sugar, woollen mills etc. have to buy raw materials in a particular season as their  sales are made largely in that season. So, their working capital requirements are more during that season in which they have to buy raw materials for manufacturing.

It would be impracticable to attempt to draw up any formula for calculating the amount of working  capital required in any given concern. We must content ourselves with the general statement that working capital requirements vary roughly in proportion to the volume of business, the length of period of manufacture, and the average length of the credit extended to customers, and the extent of seasonal variation in volume of business. These vary roughly inversely to the rapidity of turn-over, length of the credit obtained in purchase of goods and the facilities available for converting current assets into cash. These are the factors to be taken into account. Since the customary units of time used in reckoning most commercial operations is the month, it is worthwhile to make estimates of the working capital requirements on a month to month basis.

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