A business undertaking should plan its operations in such a way that it should have neither too much nor too little working capital. There are no set of rules or formulae to determine the working capital requirements of a firm. The total working capital requirement is determined by a wide variety of factors. These factors, however, affect different firms’ differently. Also, the relative importance of these factors changes even in the same firm in course of time. Therefore, an analysis of relevant factors should be made in order to determine the total investment in working capital. A brief description of the general factors influencing working capital needs of a firm are as follows:
1. Nature of Business: The amount of working capital is basically related to the nature of business. The proportion of current assets needed in some lines of business activity varies from other lines. For instance, trading and finance firms have a very small investment in fixed assets, but they require more working capital. In contrast, public utility concerns rendering public services require a huge investment in fixed assets. The requirement of current assets in such concerns is usually less due to cash nature of business and selling service. In trading concerns, the amount of working capital required is less than the manufacturing concern, since there is no production of goods and services involved, but in the service industry, like banks, the amount of working capital required is very high. The relative importance of current assets to total assets will indicate the required intensity of planning and control efforts in working capital management area. [ Factors Influencing Working Capital ] 2. The size of Business: It may be argued that a firm’s size, measured in terms of assets or sales, affects the need for working capital. Size may be measured in terms of a scale of operation. A firm having with large-scale operations will need more working capital required then a small firm having small-scale operations. A small firm may use extra current assets as a cushion
against cash flow interruptions.Bigger firms have many sources of funds, thereby it will require less amount of working capital as compared to the smaller ones. [ Factors Influencing Working Capital ] 3. Production Cycle Process: This is another factor, which has bearing on the quantum of working capital, is the production cycle. The term production or manufacturing cycle refers to the time involved in the manufacturing of goods. It covers the time span between the procurement of raw materials and the completion of the manufacturing process leading to the
production of finished goods. Longer the production cycle, the higher will be the working capital requirement and vice versa. Manufacturing firms have large production cycle, so they require high working capital, but in the case of the short production, cycle firms require less working capital. Working capital requirements can be reduced with the help of certain policy steps, like terms of credit for raw materials and the suppliers. Unless the sequences of production process leading to conversion into finished goods are kept under close observation to achieve better production and productivity, more and more working capital funds will be tied up. In this context, it should be noted that production planning and control are vital. [ Factors Influencing Working Capital ] 4. Production Policy: Production policy means whether it is continuous or seasonal demand for products. What kind of production policy should be followed in above cases? There are two options to such companies, either they confine their production only to periods when goods are purchased or they follow a steady production policy throughout the year and
produce goods at a level to meet peak demand. Suppose in the case where, production and sales go simultaneously, the amount of working capital required is less ( an example is FMCG goods business), but the sales will be only seasonal and production will take place throughout the year thus continuously the amount of working capital required is very high. (Umbrella business). [ Factors Influencing Working Capital ] 5. Credit Policy or Terms of Purchase and Sales:The credit policy relating to sales and purchases also affects the working capital. If a company purchases raw materials in cash and sells goods on credit, it will require a larger amount of working capital. On the contrary, a concern having credit facilities for the purchase of raw materials and allowing no credit to its customers will require a lesser amount of working capital. [ Factors Influencing Working Capital ] 6. Business Cycle: The amount of working capital requirements of a firm varies with every movement of the business cycle. The variations in business conditions may be in two directions (a) Upward phase – when boom conditions prevail, in this case, more working capital is required to cover the lag between the increased sales and receipt of cash as well as to finance purchase of additional material. (b) Downswing phase – in this case, the need for working capital will be very less, since there is no growth in sales. [ Factors Influencing Working Capital ] 7. Growth and Expansion: As the company grows, it is logical to expect that a larger amount of working capital in required. It is very difficult to determine the relationship between the growth in the volume of business of a company and increase in its working capital required. Other things being equal, growth industries require more working capital than those the static. The critical fact, however, is that the need for increased working capital funds does not follow the growth in business activities but proceeds it. Advance planning of working capital is, therefore, a continuing necessity for a growing concern, or else, the company may have substantial earnings but little cash. [ Factors Influencing Working Capital ] 8. Scarce Availability of Raw Materials: The availability of certain raw materials on a continuous basis without interruption would sometimes affect the working capital requirement. There may be some materials, which cannot be procured easily either because of either their sources are few or they are irregular. Therefore, the firm might be compelled to purchase more than required to manage smooth production. In this case, the amount of working capital required is large. In another case, the availability of raw materials are easy and there are no fluctuations thus the amount of working capital required is less. [ Factors Influencing Working Capital ] 9. Profit Level: Firms may differ in their capacity to generate profit from the business. Some firms enjoy a dominant position, due to a quality product or good marketing management or monopoly power in the market and earn a high-profit margin. Other firms may earn low profits. The net profit is a source of working capital to the extent that it has been earned in cash.
A high net profit margin contributes towards the working capital pool. A firm with high-profit level requires less working capital and vice versa. [ Factors Influencing Working Capital ] 10. The level of Taxes: The net profit is calculated after deduction of tax. The amount of taxes to be paid is determined by the tax authorities. So the management has no discretion in this respect. Hence, companies very often pay taxes in advance on the basis of the profit of the previous year. Therefore, the tax is an important aspect of working capital planning. If tax liability
increases, it leads to an increase in the requirement of working capital and vice versa. So tax planning can, therefore, be said to be an integral part of working capital planning. [ Factors Influencing Working Capital ] 11. Dividend Policy: Dividend has a bearing on working capital since it is appropriation profits. The payment of dividend reduces cash resources and thereby, affects working capital to that extent. Conversely, if the firm does not pay dividends but retains profits, the working capital increases. In other words, declaration of dividends leads to more working capital requirement and vice versa. [ Factors Influencing Working Capital ] 12. Depreciation Policy: It also exerts an influence on the quantum of working capital required. Depreciation charge is out of pocket cost. The effect of depreciation policy on working capital is indirect. More depreciation provisions reduce the amount of required working capital and vice versa. 13. Price Level Changes: Increasing prices necessitate the use of more funds for managing an existing level of activity. In the same level of current assets, higher cash outlays is required. The effect of raising prices is that a higher the amount of working capital is required. However, in the case of companies, which can raise their prices proportionately, there is no serious problem regarding working capital required. Moreover, the price rise does not have a uniform effect on all commodities. The effects of raising price levels will be different for different firms depending upon their pricing policies, nature of the product etc. 14. Operating Efficiency: The operating efficiency of the firm relates to the optimum utilisation of resources at minimum costs. The efficiency of operations accelerates the pace of cash cycle and involves the working capital turnover. In this case, the amount of working capital needed is less since it releases pressure by improving profitability and improving the internal generation of funds. 15. Availability of Credit: The need for working capital in a firm will be less if it avails liberal credit facilities. Similarly, the availability of credit from banks also influences the working capital needs of the firm. A firm enjoying bank credit facilities can secure funds to finance its working capital requirement very easily, whenever it requires. It can, therefore,
perform its business activities with less working capital than a firm without such credit facility. 16. Other Factors: In addition to the above factors, there are a number of other factors, which affect the requirement of working capital. Some of them are close coordination between production and distribution policies, an absence of specialisation in the distribution of products, the means of transportation and communication, the hazards and contingencies inherited in a particular type of business, credit policy of RBI and so on.
The amount of working capital is also influenced by the inventory policies, depreciation policies, management attitude and wages and government policies.