What are the determinants of Working Capital?

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determinants of working capital
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Determinants of Working Capital

In Financial Management there is no set formula or rule to determine the requirement of working capital in a business. There are large numbers of factors that could be the determinants of working capital in an organisation. In addition to this, the importance of a factor also changes over time for a firm. It is very important for a firm to do a proper analysis and find out the factors that influence the working capital requirements.

The determinants of working capital in a firm are given below –

1. Nature of Business

Working Capital requirement in an organisation is also affect by the nature of business. For example , a trading or financing firm do not require much amount of fixed assets. However they invest huge amount of working capital to run day to day affairs of the business. Similarly retail and departmental stores requires to hold a large stock of goods so they also require huge quantity of working capital.

On the other hand public utilities firms requires more of fixed assets. Hence their investment in working capital is comparatively lower than that of other firms. But in case of manufacturing companies, they requires both so they fall somewhat in between the trading firms and public utilities.

2. Technology and Manufacturing Policy

The manufacturing process involves procurement of raw material, use of raw material and then conversion of it into finished goods. So, as long as the manufacturing cycle, as large the need of working capital by an organisation. But if technology is also added to the manufacturing cycle, it will shorten the manufacturing process, hence the period of conversion of raw material to finished good will also get shorten. This will result in reducing the working capital requirements. So, it is one of the most important decision that firm has to take whether they want to add technology in the production process or not.

3. Credit Policy

Credit Policy is another important determinant of Working capital. If a firm is adopting a liberal credit policy that means that it is granting credit to customers without looking at the credit worthiness of the customers. This could result in receiving late payments from the customers. The collection period will increase. If firm is not able to collect the payment then it could also result in bad debts. So it is very important that firms design a credit policy in which they grant credit to customers seeing their credit worthiness and with less procedures.

4. Market and Demand Conditions

The demand in the market also play an important role in determining working capital for the firm. For example, in lean season the demand is low, hence firm do not require to produce more so less working capital will be required. However in peak seasons, demand increases. This result in more production. More production leads to increase in the working capital need.

5. Changes in Price Level

The changes in prices also affect the working capital. For example, if prices of raw material increases, it will result in requiring more working capital as more cash is required to purchase the raw material. However a firm that increases the prices of its product with the increase in the prices, such firms do not have to face this problem.

6. Operating Efficiency

The operating efficiency refers to the optimum utilization of resources by the firm by spending minimum. Firm should try to control the operating costs and utilize fixed and current assets efficiently so that operating efficiency could be achieved. This will increase the speed of cash conversion cycle as well as improvement in the use of Working Capital.

7. Availability of Credit from Suppliers

Firm’s working capital requirement is also affected by the terms of credit given by the suppliers. If the supplier is providing credit to firm on liberal terms, then they will require less amount of working capital and vice versa. However, in absence of supplier credit, firm can borrow funds from banks.

Related Financial Terms of Working Capital

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