Question

Answer the following question.

Discuss the factors determining working capital requirement.

Answer 1

Meaning 

Working capital is the capital that is used to carry out the day to day business activities. The business firm has to arrange capital for making an investment in short term assets such as cash, account receivable, inventory, etc.

The capital invested in these assets is referred to as 'Working Capital. An investor invests money in working capital for getting an immediate return.

Definition:

According to Gerstenbergh, "Working capital is the excess of current assets over liability". This approach is called Net Working Capital.

Factors affecting working capital requirement:

There are no precise standards to measure working capital adequacy. Management has to determine the size of working capital in the light of certain aspects of the business firm and the economic environment within which the firm operates.

1. Nature of business: Firms engaged in manufacturing essential products of daily consumption would need relatively less working capital as there would be constant and sufficient cash inflow in the firm to take care of liabilities. Likewise, public utility concerns have to maintain small working capital because of continuous flow of cash from their customers.

2. Public utility concern: These concerns provide services such as transport, gas, electricity, etc.
On the contrary, if the business is dealing with luxurious products, it requires a huge amount of working capital, as sale of luxurious items are not frequent.
Trading/merchandising firms that are concerned with the distribution of goods have to carry big inventories of goods to meet customer's demand and have to extend credit facilities to attract customers. Hence they need a large amount of working capital.
Merchandising firms are those which are concerned with buying and selling of goods, either as wholesaler or retailer, without altering the physical form of goods.

3. Size of business: The size of the business also affects the requirement of working capital. A firm with large scale operations will require more working capital.

4. The volume of sales: This is the most important factor affecting the size of working capital. The volume of sales and the size of working capital are directly related to each other. If the volume of sales increases, there is an increase in the amount of working capital and vice versa.

5. Production cycle: The process of converting raw material into finished goods is called production cycle.
If the period of the production cycle is longer, then the firm needs more amount of working capital. If the manufacturing cycle is short, it requires less working capital.

6. Business cycle: When there is a boom in the economy, sales will increase. This will lead to an increase in investment in stocks. This requires additional working capital. During a recession, sales will decline and hence the need for working capital will also decline.

7. Terms of purchases and sales: If the firm does not get credit facility for purchases but adopts a liberal credit policy for its sales, then it requires more working capital. On the other hand, if credit terms of purchases are favourable and terms of credits sales are less liberal, then the requirement of cash will be less. Thus working capital requirements will be reduced.

8. Credit control: Credit control includes factors such as the volume of credit sales, the terms of credit sales, the collection policy, etc. If a credit control policy is sound, it is possible for the company to improve its cash flow. If credit policy is liberal, it creates a problem of the collection of funds. It can increase the possibility of bad debts. Therefore a firm requires more working capital. The firm making cash sales requires less working capital.

9. Growth and Expansion :
The working capital requirement of a firm will increase with the growth of a firm. A growing company needs funds continuously to support large scale operations.

10. Management ability :
The requirement of working capital is reduced if there is proper co-ordination between the production and distribution of goods. A firm stocking on heavy inventory calls for a higher-level for working capital.

11. External factors :
If financial institutions and banks provide funds to the firm as and when required, the need for working capital is reduced.