Determinants of Working Capital
Working capital, which is the difference between a company’s current assets and current liabilities, is crucial for the day-to-day financial operations of a business. It’s used to fund operations and short-term obligations. Several factors can affect the level of working capital a company needs. These factors, known as the determinants of working capital, can include:
- Nature of the Business: Different types of businesses have different working capital requirements. A retail business, for instance, may require more working capital because it needs to maintain high inventory levels. On the other hand, a service business with few tangible goods might require less.
- Size of the Business: Larger businesses typically need more working capital due to their scale of operations.
- Business Cycle and Seasonality: Certain times of the year may require more working capital. For instance, a toy manufacturer may need more working capital during the holiday season when demand is high.
- Production Cycle: The longer the production cycle, the more the working capital required as raw materials, work-in-progress inventory, and finished goods need to be maintained for a longer period.
- Credit Policy: If a company’s policy is to sell goods on credit and it takes a longer time to collect accounts receivable, it may require more working capital. Conversely, if the company can delay its payables, it may require less working capital.
- Growth and Expansion Activities: Companies that are in a growth phase or planning to expand often require additional working capital to fund new projects and ventures.
- Economic Conditions: In a recession, sales may decline, and customers may take longer to pay their bills, which can increase the need for working capital.
- Access to Credit: Companies that have easy access to credit may operate with less working capital because they can borrow quickly if they need funds.
Understanding these determinants can help a company plan its finances and ensure it maintains an adequate level of working capital to sustain its operations and meet its short-term obligations.
Example of the Determinants of Working Capital
Let’s consider a manufacturing company to demonstrate how various determinants of working capital come into play.
- Nature of the Business: As a manufacturer, the company needs a significant amount of working capital to purchase raw materials, pay workers, and maintain inventory before it’s sold to customers.
- Size of the Business: This is a large-scale manufacturing company, producing thousands of units each month, requiring a higher level of working capital compared to a smaller manufacturer.
- Business Cycle and Seasonality: Suppose this company manufactures outdoor furniture, and the demand for its products peaks during the spring and summer. Therefore, it would need more working capital during these seasons to ramp up production and build inventory.
- Production Cycle: The manufacturing process for the furniture takes several weeks from the time raw materials are received until the finished product is ready for sale. This long production cycle necessitates a higher level of working capital.
- Credit Policy: The company sells its furniture to retailers, allowing them to pay within 60 days. This means the company must have enough working capital to continue operations while waiting for these payments.
- Growth and Expansion Activities: If the company plans to introduce new product lines or expand into new markets, it would need additional working capital to fund these initiatives.
- Economic Conditions: During a recession, the company might face lower demand for its products, leading to slower sales and longer collection periods. This could increase the need for working capital.
- Access to Credit: The company has a good relationship with its bank and can obtain short-term loans easily. This access to credit provides a safety net, potentially reducing the amount of working capital the company needs to keep on hand.
By considering these factors, the company can estimate its working capital needs and plan accordingly, ensuring it has enough liquidity to operate smoothly and meet its short-term obligations.