11 Determinants of Working Capital | Financial Management

Some of the most determinants of working capital are: 1. Nature of business 2. Length of period of manufacture 3. Volume of business 4. The proportion of the cost of raw materials to total cost 5. Use of Manual Labour or Mechanisation 6. Need to keep large stocks of raw materials of finished goods 7. Turnover of working capital 8. Terms of Credit 9. Seasonal Variations 10. Requirements of Cash and 11. Other Factors.

The requirements of working capital are not uniform in all enterprises, and therefore, factors responsible for a particular size of working capital in one company are different than in other enterprise.Therefore, a set pattern of factors determining the optimum size of working capital is difficult to suggest.

1. Nature of business:

It is an important factor for determining the amount of working capital needed by various companies. The trading or manufacturing concerns will require more amount of working capital along-with their fixed investment of stock, raw materials and finished products.

Public utilities and railway companies with huge fixed investment usually have the lowest needs for current assets, partly because of cash, nature of their business and partly due to their selling a service instead of a commodity. Similarly, basic and key industries or those engaged in the manufacture of producer’s goods usually have less proportion of working capital to fixed capital than industries producing consumer goods.

2. Length of period of manufacture:

The average length of the period of manufacture, i.e., the time which elapses between the commencement and end of the manufacturing process is an important factor in determining the amount of the working capital.

If it takes less time to make the finished product, the working capital required will be less. To give an example, a baker requires one night time to bake his daily quota of bread. His working capital is, therefore, much less than that of a ship­building concern which takes three to five years to build a ship. Between these two cases may fall other business concerns with varying periods of manufacture requiring different amounts of working capital.

3. Volume of business:

Generally, the size of the company has a direct relation with the working capital needs. Big concerns have to keep higher working capital for investment in current assets and for paying current liabilities.

4. The proportion of the cost of raw materials to total cost:

Where the cost of raw materials to be used in manufacturing of a product is very large in proportion to the total cost and its final value, working capital required will also be more.

That is why, in a cotton textile mill or in a sugar mill, huge funds are required for this purpose. A building contractor also needs huge working capital for this reason. If the importance of materials is less, as for example in an oxygen company, the needs of working capital will be naturally not more.

5. Use of Manual Labour or Mechanisation:

In labour intensive industries, larger working capital will be required than in the highly mechanized ones. The latter will have a large proportion of fixed capital. It may be remembered, however, that to some extent the decision to use manual labour or machinery lies with the management. Therefore, it is possible in most cases to reduce the requirements of working capital and increase investments in fixed assets and vice versa.

6. Need to keep large stocks of raw materials of finished goods:

The manufacturing concerns generally have to carry stocks of raw materials and other stores and also finished goods. The larger the stocks (whether of raw materials or finished goods) more will be the needs of working capital.

In certain lines of business, e.g., where the materials are bulky and have to be purchased in large quantities, (as in cement manufacturing), stock piling of raw-material is used.

Similarly, in public utilities, which must have adequate supplies of coal to assure regular service, stock piling of coal is necessary. In seasonal industries finished goods stocks have to be stored during off seasons. All these require large working capital.

7. Turnover of working capital:

Turnover means the speed with which the working capital is recovered by the sale of goods. In certain businesses, sales are made quickly and the stocks are soon exhausted and new purchases have to be made. In this manner, a small amount of money invested in stocks will result in sales of much larger amount.

Considering the volume of sales, the amount of working capital requirements will be rather small in such type of business. There are other businesses where sales are made irregularly. For example, in case of jewellers, a costly jewellery may remain locked up in the show-window for a long period before it catches the fancy of a rich lady.

In such cases, large sums of money have to be kept invested in stocks. But a baker or a news-hawker may be able to dispose of his stocks quickly, and may, therefore, need much smaller amounts by way of working capital.

8. Terms of Credit:

A company purchasing all raw-materials for cash and selling on credit will be requiring more amount of working capital. Contrary to this, if the enterprise is in a position to buy on credit and sell it for cash, it will need less amount of working capital. The length of the period of credit has a direct bearing on working capital.

The essence of this is that the period which elapses between the purchase of materials and sale of finished goods and receipts of sale proceeds, will determine the requirements of working capital.

9. Seasonal Variations:

There are some industries which either produce goods or make sales only seasonally. For example, the sugar industry produces practically all the sugar between December and April and the woollen textile industry makes its sales generally during winter.

In both these cases the needs of working capital will be very large, during few months {i.e., season). The working capital requirements will gradually decrease as and when the sales are made.

10. Requirements of Cash:

The need to have cash in hand to meet various requirements e.g., payment of salaries, rents, rates etc., has an effect on the working capital. The more the cash requirements the higher will be working capital needs of the company and vice versa.

11. Other Factors:

In addition to the above mentioned considerations there are also a number of other factors which affect the requirements of working capital. Some of them are given below.

(i) Degree of co-ordination between production and distribution policies.

(ii) Specialisation in the field of distribution.

(iii) Developments of means of transportation and communications.

(iv) The hazards and contingencies inherent in the type of business.

Submitted by : Professor Ashavari, Category : Finance, Tag : Working Capital