What are the Determinants of Working Capital?

Sound financial and statistical techniques, supported by value judgment should be used to predict the quantum of working capital required at different times. Some of the factors which need to be considered while planning for the working capital requirement are:-

1. Nature of Business: A company’s working capital requirements are directly related to the kind of business it conducts. A company that sells a service primarily on a cash basis does not have the pressure of keeping considerable amounts of inventories or of carrying customer’s receivables. On the other hand, a manufacturing enterprise ordinarily finances its own customers, requires large amounts to pay its own bills, and uses inventories of direct materials for conversion into end products. These conditions augment the working capital requirements.

2. Degree of Seasonality: Companies that experience strong seasonal movements have special working capital problems in controlling the internal financial savings that may take place. Aggravating this difficulty is the fact that no matter how clearly defined a pattern may be, it is never certain. Unusual circumstances may distort ordinary relationships. Although seasonality may pull financial managers from the security of fixed programs to meet recurring requirements, flexible arrangements are preferable to guard against unforeseen contingencies. An inability to cope with sharp working capital swings is one of the factors that encourage companies to undertake diversification programs.

3. Production Policies: Depending upon the kind of items manufactured, by adjusting its production schedules a company may be able to offset the effect of seasonal fluctuations upon working capital, at least to some degree, even without seeking a balancing diversified line.

4. Growth Stage of Business: As a company expands, it is logical to expect that larger amounts of working capital will be required to avoid interruptions to the production sequence. Although this is true it is hard to draw up firm rules for the relationship between the growth in the volume of a company’s business and the growth of its working capital. A major reason for this is management’s increasing sophistication in handling the current assets, besides other factors operating simultaneously.

5. Position of the Business Cycle: In addition to the long-term secular trend, the recurring movements of the business cycle influence working capital changes. As business recedes, companies tend to defer capital replacement programs and deflect depreciations to liquid balances rather than fixed assets. Similarly, curtailed sales reduce amounts receivable and modify inventory purchases, thereby contributing further to the accumulation of cash balances. Conversely, the sales, capital, and inventory expansions that accompany a boom produce a greater concentration of credit items in the balance sheet.

6. Competitive Conditions: A corporation that dominates the market may relax its working capital standard because failing to meet customers’ requirements promptly does not necessarily lead to a loss of business. When competition is keen, there is more pressure to stock varied lines of inventory to satisfy customer’s demands and to grant more generous credit terms, thereby causing an expansion in receivables.

7. Production Collection Time Period: Closely related to a company’s competitive status are the credit terms, it must grant. These arrangements may be the result of tradition, policy within the industry, or even carelessness in failing to carry out announced principles. And the arrangements, in turn, are part of the overall production collection time sequence, that is, the time intervening between the actual production of goods and the eventual collection of receivables, flowing from sales. The length of this period is influenced by various factors.

8. Dividend Policy: A desire to maintain an established dividend policy may affect the volume of working capital or changes in working capital may bring about an adjustment of dividend policy. In either event, the relationship between dividend policy and working capital is well established, and very few companies ever declare a dividend without giving consideration to its effect on cash and their needs for cash.

9. Size of Business: The amount needed may be relatively large per unit of output for a small company subject to higher overhead costs, less favorable buying terms, and higher interest rates. Small though growing companies tend to be hard-pressed in financing their working capital needs because they seldom have access to the open market as do large established business firms have.

10. Sales Policies: Working capital needs vary on the basis of the sales policy of the same industry. A department store that caters to the “carries trade” by carrying a quality line of merchandise and offering extensive charge accounts will usually have a slower turnover of assets, a higher margin on sales, and relatively larger accounts receivable than many of its non-carriage, trade competitors. Another department store that stresses cash and carries operations will usually have a rapid turnover, a low margin on sales, and small or no accounts receivable.

11. Risk Factor: The greater the uncertainty of receipt and expenditure, the more they need for working capital. A business firm producing an item that sells for a small unit price and which necessitates repeat buying, such as canned foods or staple dry goods, etc., would be subject to less risk than a firm producing a luxury item that sells for a relatively high price and is purchased once over a period of years, such as furniture, automobiles
etc.

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