Factors Determining Working Capital Requirements

Prerequisites

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1. Why do different firms need different amounts of WC?

There is no "one size fits all" formula for working capital. A software company might need very little, whereas a car manufacturer needs massive amounts.

2. Key Determining Factors

The amount of working capital a firm needs depends on several factors:

2.1 Nature of Business

• Manufacturing Firms: Need high working capital (funds tied in raw material, work-in-progress, and finished goods).
• Trading Firms: Need moderate working capital (funds tied mainly in stock-in-trade).
• Service Firms: Need low working capital (no physical product to stock; e.g., a consultancy).
• Public Utilities: (Electricity, Railways) Need very low working capital as they sell for cash and have no inventory.

2.2 Size of Business

• Naturally, a large-scale operation needs more funds for inventory and debtors compared to a small-scale unit.

2.3 Length of Production Cycle

• The time taken to convert raw materials into finished goods.
• Longer Cycle: (e.g., Shipbuilding) More funds are tied up in "Work-in-Progress" for a long time. High WC needed.
• Shorter Cycle: (e.g., Bakery) Quick conversion. Low WC needed.

2.4 Business Cycle Fluctuations

• Boom Phase: Sales are high, so more inventory and debtors are maintained. High WC needed.
• Depression Phase: Sales are low, production is cut. Low WC needed.

2.5 Seasonal Variations

• Some businesses are seasonal (e.g., Air conditioners, Umbrellas).
• They need Peak Capital during the busy season to build up stock.

2.6 Credit Policy (Terms of Purchase and Sale)

• Liberal Sales Credit: If you allow customers to pay after 90 days, your funds are blocked in debtors. High WC needed.
• Liberal Purchase Credit: If your suppliers allow you to pay after 60 days, you are using their money. Low WC needed.

2.7 Growth and Expansion

• A fast-growing company needs more working capital every month to fund increasing sales and production.

2.8 Operating Efficiency

• If a firm can manage its stock efficiently and collect cash from debtors quickly (High Inventory Turnover), it needs less working capital.

3. Summary Table: High vs. Low WC Needs

Exam Pattern Questions and Answers

Question 1: "Explain any five factors that determine the working capital requirements of a firm." (8 Marks)

Answer: The working capital requirement of a firm is influenced by various factors:

1. Nature of Business (2 marks): Manufacturing concerns require a large amount of working capital because they have to maintain stocks of raw materials, work-in-progress, and finished goods. On the other hand, public utility concerns like electricity companies need less working capital as they mostly deal for cash and have minimal inventory.
2. Length of Production Cycle (1.5 marks): It refers to the time gap between the purchase of raw materials and the production of finished goods. The longer this period (e.g., in heavy engineering), the more funds are blocked in work-in-progress, resulting in a higher requirement for working capital.
3. Credit Policy (1.5 marks): A firm that allows liberal credit to its customers (debtors) will have more funds blocked in accounts receivable and thus will need more working capital. Conversely, if the firm gets long credit periods from its own suppliers, its own working capital requirement decreases.
4. Business Cycle (1.5 marks): During a period of boom, the economy is active, sales are high, and the firm may need to increase production and maintain more stock. This increases the working capital requirement. The opposite happens during a recession.
5. Operating Efficiency (1.5 marks): A firm that can convert its inventory into sales quickly and collect cash from its debtors without delay can operate with a smaller amount of working capital. Efficient management reduces the "idle" time of funds.

Summary

1. Manufacturing and Long Cycle businesses need more money.
2. Cash-sales and Service businesses need less money.
3. Credit Policy is a major controllable factor.
4. Efficiency in managing assets directly reduces the need for funds.

Quiz Time! 🎯

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