Question

You are the finance manager of a company. The board of directors has asked you to determine the working capital requirement for the company.

State the factors that you would take in consideration while determining the requirement of working capital for the company?

Answer 1

The finance manager must keep in mind following factors before estimating the amount of working capital.

1. Length of Operating Cycle:

The amount of working capital directly depends upon the length of operating cycle. Operating cycle refers to the time period involved in production. It starts right from acquisition of raw material and ends till payment is received after sale.The working capital is very important for the smooth flow of operating cycle. If operating cycle is long then more working capital is required whereas for companies having short operating cycle, the working capital requirement is less.

2. Nature of Business:

The type of business, firm is involved in, is the next consideration while deciding the working capital. In case of trading concern or retail shop the requirement of working capital is less because length of operating cycle is small.

3. Scale of Operation:

The firms operating at large scale need to maintain more inventory, debtors, etc. So they generally require large working capital whereas firms operating at small scale require less working capital.

4. Business Cycle Fluctuation:

During boom period the market is flourishing so more demand, more production, more stock, and more debtors which mean more amount of working capital is required. Whereas during depression period low demand less inventories to be maintained, less debtors, so less working capital will be required.

5. Seasonal Factors:

The working capital requirement is constant for the companies which are selling goods throughout the season whereas the companies which are selling seasonal goods require huge amount during season as more demand, more stock has to be maintained and fast supply is needed whereas during off season or slack season demand is very low so less working capital is needed.

6. Technology and Production Cycle:

If a company is using labour intensive technique of production then more working capital is required because company needs to maintain enough cash flow for making payments to labour whereas if company is using machine-intensive technique of production then less working capital is required because investment in machinery is fixed capital requirement and there will be less operative expenses.

7. Credit Allowed:

Credit policy refers to average period for collection of sale proceeds. It depends on number of factors such as creditworthiness, of clients, industry norms etc. If company is following liberal credit policy then it will require more working capital whereas if company is following strict or short term credit policy, then it can manage with less working capital also.

8. Credit Avail:

Another factor related to credit policy is how much and for how long period company is getting credit from its suppliers. If suppliers of raw materials are giving long term credit then company can manage with less amount of working capital whereas if suppliers are giving only short period credit then company will require more working capital to make payments to creditors.

9. Operating Efficiency:

The firm having high degree of operating efficiency requires less amount of working capital as compared to firm having low degree of efficiency which requires more working capital.

10. Availability of Raw Materials:

If raw materials are easily available and there is ready supply of raw materials and inputs then firms can manage with less amount of working capital also as they need not maintain any stock of raw materials or they can manage with very less stock.

11. Level of Competition:

If the market is competitive then company will have to adopt liberal credit policy and to supply goods on time. Higher inventories have to be maintained so more working capital is required. A business with less competition or with monopoly position will require less working capital as it can dictate terms according to its own requirements.

12. Inflation:

If there is increase or rise in price then the price of raw materials and cost of labour will rise, it will result in an increase in working capital requirement.