DETERMINANTS OF WORKING CAPITAL
Working capital management is concerned with:-
a) Maintaining adequate working capital (management of the level of individual current assets and the current liabilities) and
b) Financing of the working capital.
For the point a) above, a Finance Manager needs to plan and compute the working capital requirement for its business. And once the requirement has been computed he needs to ensure that it is financed properly. This whole exercise is nothing but Working Capital Management.
Sound financial and statistical techniques, supported by judgment should be used to predict the quantum of working capital required at different times.
Some of the factors which need to be considered while planning for working capital requirement are:-
1. Cash – Identify the cash balance which allows for the business to meet day-to- day expenses, but reduces cash holding costs.
2. Inventory – Identify the level of inventory which allows for uninterrupted production but reduces the investment in raw materials and hence increases cash flow; the techniques like Just in Time (JIT) and Economic order quantity (EOQ) are used for this.
3. Receivables – Identify the appropriate credit policy, i.e., credit terms which will attract customers, such that any impact on cash flows and the cash conversion cycle will be offset by increased revenue and hence Return on Capital (or vice versa). The tools like Discounts and allowances are used for this.
4. Short-term Financing Options – Inventory is ideally financed by credit granted by the supplier; dependent on the cash conversion cycle, it may however, be necessary to utilize a bank loan (or overdraft), or to “convert debtors to cash” through “factoring” in order to finance working capital requirements.
5. Nature of Business - For e.g. in a business of restaurant, most of the sales are in Cash. Therefore need for working capital is very less.
6. Market and Demand Conditions - For e.g. if an item’s demand far exceeds its production, the working capital requirement would be less as investment in finished goods inventory would be very less.
7. Technology and Manufacturing Policies - For e.g. in some businesses the demand for goods is seasonal, in that case a business may follow a policy for steady production through out over the whole year or instead may choose policy of production only during the demand season.
8. Operating Efficiency – A company can reduce the working capital requirement by eliminating waste, improving coordination etc.
9. Price Level Changes – For e.g. rising prices necessitate the use of more funds for maintaining an existing level of activity. For the same level of current assets, higher cash outlays are required. Therefore the effect of rising prices is that a higher amount of working capital is required.
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