Working Capital Needs - Financial Planning and Administration, Business Economics & Finance | Business Economics & Finance - B Com PDF Download

The Need or Objects or Working Capital

The need for working capital arises due to time gap between production and realisation of cash from sales. There is an operating cycle involved in sales and realisation of cash. There are time gaps in purchase of raw materials and production, production and sales, and sales and realisation of cash. Thus, working capital is needed for following purposes.

1. For purchase of raw materials, components and spares.
2. To pay wages and salaries.
3. To incur day-to-day expenses and overhead costs such as fuel, power etc.
4. To meet selling costs as packing, advertisement
5. To provide credit facilities to customers.
6. To maintain inventories of raw materials, work in progress, stores and spares and finished stock.

Greater size of business unit large will be requirements of working capital. The amount of working capital needed goes on increasing with growth and expansion of business till it attains maturity. At maturity the amount of working capital needed is called normal working capital.

Factors Determing the Working Capital Requirements

The following are important factors which influence working capital requirements:

1. Nature or Character of Business: The working capital requirements of firm depend upon nature of its business. Public utility undertakings like electricity, water supply need very limited working capital because they offer cash sales only and supply services, not products, and such no funds are tied up in inventories and receivables whereas trading and financial firms require less investment in fixed assets but have to invest large amounts in current assets and as such they need large amount of working capital. Manufacturing undertaking require sizeable working capital between these two.

2.Size of Business/Scale of Operations: Greater the size of a business unit, larger will be requirement of working capital and vice-versa.

3.Production Policy: The requirements of working capital depend upon production policy. If the policy is to keep production steady by accumulating inventories it will require higher working capital. The production could be kept either steady by accumulating inventories during slack periods with view to meet high demand during peak season or production could be curtailed during slack season and increased during peak season.

4.Manufacturing process / Length of Production cycle: Longer the process period of manufacture, larger is the amount of working capital required. The longer the manufacturing time, the raw materials and other supplies have to be carried for longer period in the process with progressive increment of labour and service costs before finished product is finally obtained. Therefore, if there are alternative processes of production, the process with the shortest production period should be chosen.

5.Credit Policy: A concern that purchases its requirements on credit and sell its products/services on cash requires lesser amount of working capital. On other hand a concern buying its requirements for cash and allowing credit to its customers, shall need larger amount of working capital as very huge amount of funds are bound to be tied up in debtors or bills receivables.

6.Business Cycles: In period of boom i.e. when business is prosperous, there is need for larger amount of working capital due to increase in sales, rise in prices etc. On contrary in times of depression the business contracts, sales decline, difficulties are faced in collections from debtors and firms may have large amount of working capital lying idle.

7.Rate of Growth of Business: The working capital requirements of a concern increase with growth and expansion of its business activities. In fast growing concerns large amount of working capital is required whereas in normal rate of expansion in the volume of business the firm may have retained profits to provide for more working capital.

8.Earning Capacity and Dividend Policy. The firms with high earning capacity generate cash profits from operations and contribute to working capital. The dividend policy of concern also influences the requirements of its working capital. A firm that maintains a steady high rate of cash dividend irrespective of its generation of profits need more working capital than firm that retains larger part of its profits and does not pay so high rate of cash dividend.

9.Price Level Changes: Changes in price level affect the working capital requirements. Generally, the rising prices will require the firm to maintain large amount of working capital as more funds will be required to maintain the same current assets. The effect of rising prices may be different for different firms.

10.Working Capital Cycle: In a manufacturing concern, the working capital cycle starts with the purchase of raw material and ends with realisation of cash from the sale of finished products. This cycle involves purchase of raw materials and stores, its conversion into stocks of finished goods through work in progress with progressive increment of labour and service costs, conversion of finished stock into sales, debtors and receivables and ultimately realisation of cash and this cycle again from cash to purchase of raw material and so on.  The speed with which the working capital completes one cycle determines the requirements of working capital longer the period of cycle larger is requirement of working capital.