Finance Planning: Working Capital and Factors Determine Working Capital Requirement (For CBSE, ICSE, IAS, NET, NRA 2022)

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Working Capital

  • Working capital represents the amount of funds invested in current assets like debtors, stock-in-trade and cash required for meeting day-to-day expenses, paying wages/salaries to its workforce and clearing dues of its creditors. It is also known as circulating capital because most of the amount invested in current assets is continuously recovered through realisations of debtors and cash sale of goods and is re-invested in current assets. It keeps on revolving from cash to current assets and back again to cash as shown in the working capital cycle here.
  • It should be noted that a part of working capital is of a permanent nature because depending on the volume of business certain amount of cash, debtors and stock-in trade shall always be maintained by every firm. This part of working capital is known as permanent or fixed working capital and must always be financed through long-term sources. The remaining part of the working capital requirement varies from period to period on account of fluctuations in the volume of business and is called fluctuating or variable working capital. This part of working capital is usually financed through short-term sources like bank overdraft, trade creditors, bills payable, etc.

Factors Determine Working Capital Requirement

Adequate working capital is very necessary for maintenance of liquidity and running the business smoothly and efficiently. The amount of working capital required varies from business to business and from period to period. The various factors that influence such requirement are as follows:

Factors Determine Working Capital Requirement

Nature of Business

The working capital requirement of the manufacturing companies is usually high as they require huge stock-in-trade (inventories) and the amount of their debtors is also expected to be large because of the credit sales involved. As against this, the public utilities like electricity and telephone companies and the concerns like hotels, restaurants, etc. can manage with small amount of working capital as most of their transactions are undertaken on cash basis and their inventory needs are low.

Size of Business

The size or volume of business plays a major role in determining the amount of working capital requirement of every firm. Obviously, larger the volume of business, larger would be the amount of working capital need. This is because, as their inventory requirement will be large and so also the amount of their debtors.

Length of Production Cycle

Length of production cycle refers to the time period involved in converting raw material into finished goods. Longer the length of such period, larger will be the requirement of working capital and vice versa. The length of production cycle, however, depends upon the type of product being manufactured and the nature of technology used. For example, in case of products like cars and cotton textiles, the production cycle is much longer than in case of items like stationery, detergents, etc. Therefore, working capital requirement is large for car companies and textile mills.

Inventory Turnover Rate

Inventory turnover rate refers to the speed at, or the time period within which finished stock is converted into sales. There is a high degree of correlation between the amount of working capital required and the inventory turnover rate. A firm having high inventory turnover rate needs less working capital as against a firm which has low inventory turnover rate. It is so because the firm with high rate can manage with less investment in stock. Take the case of a retailer dealing in fast moving items like groceries and cosmetics with a high turnover rate.

Credit Policy

The firms which provide liberal credit facility to their customers need more working capital as compared to those firms which observe strict credit terms and are efficient in realisation of their debts. It is so because when customers enjoy longer period of credit, a larger amount of firm՚s funds get tied up with debtors. This results in higher requirement of working capital.

Seasonal Fluctuations

The firms that are engaged in manufacturing products like ceiling fans or woollen garments, the demand of which is limited to a specific period of the year, require higher amount of working capital not only during the peak period but also during off season. This is so because they may be left with a good amount of unsold goods which is kept in stock for sale during the next season. There is no denying the fact that the firms dealing in consumer durables or items involving long production period or wide seasonal fluctuations require large amount of working capital.

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