Working capital is a critical factor in the success of many businesses. It is the money that the company has available to pay bills, purchase inventory, and grow their business. Working capital requirements are determined by a variety of factors, including current asset levels and forecasted future cash needs.
Content Recap:
The first factor affecting working capital requirements is current asset levels. This includes cash on hand, receivables (money owed to the company), and inventory levels. When these assets are low or declining, it can be an indicator that the business needs more working capital to cover expenses until new sales revenue comes in. The second factor affecting working capital requirements is forecasted future cash needs. These include future purchases of inventory or fixed assets, expected increases in accounts payable (bills owed to suppliers), and payroll expenses for new.
Different factors affect the working capital requirements of a company. These factors can be classified as internal and external. Internal factors include inventories, accounts receivable, and accounts payable. External factors include economic conditions, such as inflation and interest rates.
14 factors affecting the working capital requirements of a business:
- Nature of business,
- Size of business,
- Time and complexities of the manufacturing process,
- Manufacturing cost,
- Growth and Expansion,
- Terms of purchase and sales,
- Conditions of supply,
- Market conditions,
- Business cycle,
- Operating cycle,
- Rate of Turnover,
- Cash requirements,
- Seasonal variations, and
- Other factors.
Now let’s discuss factors determining working capital requirements.
1. Nature of Business
The amount of working capital required depends on the kind or nature of business a company performs:
- In the case of public utilities, less capital is required. It is so, since, they don’t have any stock in trade and they sell on a cash basis.
- Companies involved in trading and providing services require more working capital because they have to keep a lot of stock-in-trade. They also have to maintain a lot of liquid cash, bills receivable, and so on.
- Manufacturing companies need more working capital to continue production if they use imported and costly raw materials.
- Labor-intensive industries also require more working capital because they have to spend a lot of money on giving wages and salaries to workers or employees.
- Capital-intensive industries need less working capital because they have to depends more on machines and less on the workers.
2. Size of Business
The size of a business determines the amount of working capital that is needed.
For, e.g., bigger companies require more working capital than smaller ones.
3. Time and Complexities of Manufacturing Process
The time and complexities involved in the manufacturing process affect the amount of working capital that is required:
- If the manufacturing process is long and complicated, then more working capital is required. For example, companies manufacturing automobiles need more working capital.
- If the manufacturing process is short and simple, then less working capital is required. For example, companies involved in manufacturing soaps require less working capital.
4. Manufacturing Cost
The manufacturing cost is another factor that determines, how much working capital is needed.
For example, if the production cost of a product is high then the working capital required is also more and vice versa.
5. Growth and Expansion
If a company is growing and expanding its business activities, then it will need more working capital to maintain its growth.
6. Terms of Purchase and Sales
The working capital requirements of a company depends on its terms of purchase and sales:
- If it makes a purchase on credit and sells on a cash basis, then it requires less working capital.
- Conversely, if it buys with cash and sells on credit, then it will need more working capital.
7. Conditions of Supply
The working capital requirements of the company depends on the conditions of supply:
- If the supply of raw materials is regular, then the company can keep less inventory (stock). So, it will require less working capital.
- But, if the supply is irregular then the company has to hold more stock. Therefore, in such a case, it will need more working capital.
8. Market Conditions
The working capital requirements of a company depends on the degree of competition in the market.
If the competition is intense, then the company has to spend a lot of money on running advertising campaigns and sales promotions. It will also have to keep more stock and sell on credit. So, it will require more working capital.
9. Business Cycle
The working capital requirements of a company depends on the business cycle.
The business cycle consists of a boom and recession period:
- During the boom period, the sales are very high. So, in this time, the company has to spend a lot of money on raw materials, wages, etc. So, it requires more working capital.
- But, during the recession period, the sales decline as people tend to buy less. Thus, in this phase, the company needs less working capital.
10. Operating Cycle
A service company usually has a short operating cycle or period. It also sells on a cash basis. So, it requires less working capital. For example, electricity and transport companies.
A manufacturing company usually has a long operating cycle. It also sells on a credit basis. Therefore, it requires more working capital. For example, machine tools companies.
11. Rate of Turnover
The working capital requirements of a business depends on the rate of turnover or sales. If the sales are very fast, then less working capital is required and vice versa.
12. Cash Requirements
A company needs cash for paying salaries, rent, taxes, so on. If the company’s cash needs are high, then it requires more working capital. In other words, the higher the cash requirement, the greater will be the working capital required, and vice versa.
13. Seasonal Variations
The seasonal variations also influence the working capital:
- During the busy season, more working capital is required.
- During the slack (less busy) season less working capital is required.
14. Other Factors
Additional factors influencing working capital requirements:
- Transport facilities,
- Changes in the price level,
- The credit standing of the company, etc.