There are no uniform rules or formulae to determine the working capital requirements in a firm.
Determination of working
no uniform rules or formulae to determine the working capital requirements in a firm. A firm should not
plan its working capital neither too much nor too low. If it is too high it
will affect profits. On the other hand if it is too low, it will have liquidity
problems. The total working capital requirements is determined by a wide
variety of factors. They also vary from time to time. Among the various
factors, the following are necessary.
The working capital requirements
of an organization are basically influenced by the nature of its business. The
trading and financial institutions require more working capital rather than
fixed assets because these firms usually keep more varieties of stock to
satisfy the varied demands of their customers. The public utility service
organisations require more fixed assets rather than working capital because
they have cash sales only and they supply only services and not products. Thus,
the amounts tied up with stock and debtors are almost zero. Generally,
manufacturing business needs, more fixed assets rather than working capital.
Further, the working capital requirements also depend on the seasonal products.
2. Size of the business Another
important factor is the size of the business. Size of the business means scale
of operation. If the operation is on a large scale, it will need more working
capital than a firm that has a small-scale operation.
3. Operating cycle The
term “production cycle” or “manufacturing cycle” refers to the time involvement
from cash to purchase of raw materials and completion of finished goods and
receipt of cash from sales. If the operating cycle requires a longer time span
between cash to cash, the requirement of working capital will be more because
of larger tie up of funds in all the processes. If there is any delay in a
particular process of sales or collection there will be further increase in the
working capital requirements. A distillery is to make a relatively heavy
investment in working capital. A bakery will have a low working capital.
O = Duration of operating cycle
R = Raw material average storage period
W = Average period of work-in-progress
F = Finished goods average storage period
D = Debtors Collection period
C = Creditors payment period
The requirements of working capital are also determined by production policy. When the demand for the
product is seasonal, inventory must be accumulated during the off-season period
and this leads to more cost and risks. These firms, which manufacture variety
of goods, will have advantages of keeping low working capital by adjusting the
production according to season.
of Working capital The speed of working capital is
also influenced by the requirements of working capital. If the turnover is
high, the requirement of working capital is low and vice versa. Working Capital Turnover = Cost of goods sold Working capital
6. Credit Terms The level of working capital is also determined by
credit terms, which is granted to customers as well as available from its
creditors. More credit period allowed to debtors will result in high book
debts, which leads to high working capital and more bad debts. On the other
hand liberal credit terms available from creditors will lead to less working
7. Growth and Expansion As
a company grows and expands logically, it requires a larger amount of working
capital. Other things remaining same, growing industries need more working
capital than those that are static.
8. Price level changes Rising prices would necessitate
the organization to have more funds for maintaining the same level of
activities. Raising the prices in material, labour and expenses without
proportionate changes in selling price will require more working capital. When
a company raises its selling prices proportionally there will be no serious
problem in the working capital.
9. Operating efficiency Though the company cannot control
the rising price in material, labour and expenses, it can make use of the
assets at a maximum utilisation with reduced wastage and better coordination so
that the requirement of working capital is minimised.
10. Other factors Level of taxes: In this respect the management
has no option. If the government
increases the tax liability very often, taxes have to be paid in advance on the
basis of the profit on the current year and this will need more working
capital. Dividend policy: Availability
of working capital will decrease if
it has a high dividend payout ratio. Conversely, if the firm retains all the
profits without dividend, the availability of working capital will increase. In
practice, although many firms earn profit, they do not declare dividend to augment
the working capital.
Tags : Financial Management - WORKING CAPITAL MANAGEMENT
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