Determinants of working capital, Financial Management

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Q. Determinants of Working Capital?

Determinants of Working Capital: - The working capital necessity is determined by a large number of factors but generally the following factors manipulate the working capital needs of an enterprise:

(1) Nature of Business: - Working capital necessities of an enterprise are largely influenced by the nature of its business. For illustration public utilities such as transport, railways, water, electricity etc. have a very limited requirement for working capital because they have invested fairly large amounts in fixed assets.

Their working capital requirement is minimal because they get immediate payment for their services and don't have to maintain big inventories. On the other tremendous are the trading and financial enterprises which have to invest fewer amounts in fixed assets and a large amount in working capital. This is therefore because the nature of their business is such that they have to maintain a sufficient amount of cash and inventories and debtors. Working capital requirements of most of the manufacturing enterprises fall between these two extremes that is among public utilities and trading concerns.

(2) Size of Business: - Bigger the size of the business enterprise greater would be the requirement for working capital. The size of a business possibly measured in terms of scale of its business operations.

(3) Growth and Expansion: - As a business enterprise develops it is logical to expect that a larger amount of working capital will be needed. Growing industries necessitate more working capital than those that are static.

(4) Production cycle: - Production cycle signifies the time-span between the purchase of raw materials and its conversion into finished goods. The extended the production cycle the larger will be the requirement for working capital because the funds will be tied up for a longer period in work in process. If the production cycle is small the requirement for working capital will also be small.

(5) Business Fluctuations: - Business fluctuations perhaps in the direction of boom and depression. Throughout boom period the firm will have to operate at full capacity to meet the increased demand which in turn make possible increase in the level of inventories and book debts. Therefore the need for working capital in boom conditions is bound to increase. The depression stage of business fluctuations has exactly an opposite effect on the level of working capital requirement.

(6) Production Policy: - The requirement for working capital is also determined by production policy. The demand for definite products (such as woollen garments) is seasonal. Two kinds of production policies may be adopted for such products. Initially the goods may be produced in the months of demand as well as secondly the goods may be produced throughout the year. If the second substitute is adopted the stock of finished goods will accumulate progressively up to the season of demand which needs an increasing amount of working capital that remains tied up in the stock of finished goods for some months.

(7) Credit Policy Relating to Sales: - If a firm adopts moderate credit policy in respect of sales the amount tied up in debtors will as well be higher. Clearly higher book debts mean more working capital. Alternatively if the firm follows tight credit policy the scales of working capital will decrease.

(8) Credit Policy Relating to Purchase: - If a firm purchases additional goods on credit the requirement for working capital will be less. In other sense if moderate credit terms are available from the suppliers of goods that is creditors and the necessity for working capital will be reduced and vice versa.

(9) Availability of Raw Material: - If the raw material needed by the firm is available easily on a continuous basis there will be no need to keep a large inventory of such materials as well as hence the requirement of working capital will be less. Alternatively if the supply of raw material is irregular the firm will be compelled to keep an excessive inventory of such raw materials which will result in high level of working capital. As well some raw materials are available only during a particular season such as cotton, oil seeds etc. They would have to be essentially purchased in that season and have to be kept in stock for a period when supplies are lean. This will need more working capital.

(10) Availability of Credit from Banks: - If a firm is able to get easy bank facility in case of need it will operate with less working capital. Alternatively if such facility isn't available it will have to keep large amount of working capital.

(11) Volume of Profit: - The net profit is a basis of working capital to the extent it has been earned in cash. Higher net profit would produce more internal funds thereby contributing the working capital pool.

(12) Level of Taxes: - Full amount of cash profit isn't available for working capital purpose. Taxes have to be compensated out of profits. Higher the sum of taxes less will be the profits available for working capital.

(13) Dividend Policy: - Dividend policy is a important element in determining the level of working capital in an enterprise. The payment of dividend decreases the cash and thereby affects the working capital to that extent.

In contrast if the company doesn't pay dividend but retains the profits more would be the contribution of profits towards capital pool.

(14) Depreciation Policy: - Although depreciation doesn't result in outflow of cash it affects the working capital indirectly. In the initial place since depreciation is permissible expenditure in computing net profits it affects the tax liability. In the subsequent place higher depreciation as well means lower disposable profits and in turns a lower dividend payment. Therefore outgo of cash is restricted to that extent.

(15) Price Level Changes: - Changes in price level as well affect the working capital requirements. If the price level is increasing more funds will be required to maintain the existing level of production. Similar level of current assets will need bigger investment when prices are increasing.

Nevertheless companies that can immediately amend their product prices with rising price levels will not face a severe working capital problem. Therefore it is possible that some companies mayn't be affected by rising prices while others may be badly hit.

(16) Efficiency of Management: - Efficiency of management is as well a significant factor to determine the level of working capital. Management can decrease the need for working capital by the efficient utilization of resources. It is able to accelerate the pace of cash cycle and thereby use the same amount working capital again and again very quickly.

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