Factors affecting working capital: The importance of working capital for a company’s growth prospects can not be undermined. Considered the excess of a company’s current assets over its current liabilities, working capital plays a crucial role in the day-to-day operations of a business.
Having adequate working capital ensures that a company can finance its short-term expenses like salaries of the staff, purchase of raw materials, utility bills, etc.
On the other hand, insufficient working capital could lead to a business facing a cash crunch and being unable to meet its financial obligations.
Let’s then learn about the factor affecting working capital requirements, so you could ensure that your business is well-capitalised and insulated from the vagaries of cash flow inefficiencies.
10 Factors affecting working capital requirements
While there are many factors affecting the working capital requirement of a business, here we briefly explain 10 such factors that are essential for any business to consider while determining its working capital requirements.
Business Type
The position of a business in the supply chain has a bearing on its requirement for working capital. While a company engaged in the wholesaling business would require more working capital due to a longer working capital cycle, a retail shop may not require a lot of capital if the goods are sold on a cash basis only.
Similarly, a manufacturing company requires huge amount of working capital to pay its workers and converting raw material into finished goods.
Business cycle fluctuation
The economic cycle usually has a bearing on the working capital requirements of businesses.
A boom period usually leads to more demand in the economy, which prods businesses to maintain large stock to meet the demand of consumers. This requires more working capital to store more inventory.
On the contrary, during a depression period, low demand pervades the economy, and lesser working capital is required.
Credit Period
A Credit period of a Business is the time period given by a business to its customers to make full and final payment for the goods sold.
If the time period involved in the credit period is not in sync with the production cycle of the business, it can lead to a higher requirement for working capital.
Market Competition
The market competition of a business has a bearing on its requirement for working capital.
Businesses in highly competitive markets generally sell goods on credit terms to sustain and outperform their competition. This requires them to function with very high working capital.
On the other hand, a business enjoying a monopoly position is a rules-setter and can set its own price and terms of sales. This allows it to function even at low working capital since no competition exists to hamper its business.
Operating cycle
Operating cycle refers to the time period of production of goods and their delivery to the customers. Starting with the purchase of raw material, it ends till payment for the sale of finished goods is received by the business. A longer operating cycle increases the need for working capital, while a short operating cycle ensures that businesses do not have many outstanding accounts receivable.
Suggested Read: Working Capital Cycle Explained: Meaning, Steps, and Example
Seasonality
Seasons of the year can affect the availability of raw materials for businesses. This can lead to higher costs of production during certain months of the year, requiring additional working capital. On the other hand, low demand for certain products during a season can lead to a decrease in their prices, so less working capital is required.
Production cycle
The production cycle of a business entails the steps involved in the production of goods. A longer production cycle leads to more working capital requirements, while a short cycle ensures that a business quickly produces finished goods for sale, in turn requiring less working capital.
Level of technology
The type of technology used and automation have a bearing on the working capital requirements of businesses. If a business uses a labour-intensive technique for production, its expenditure would be much higher than if it were using a machine-intensive technique. This is because investment in machinery is a fixed capital requirement.
Operating efficiency
The operating efficiency of a business is one of the multiple factors that determine the amount of working capital required by a business. If a business wastes a lot of resources to convert raw material into finished goods, it would require more working capital and vice versa.
Business Size
Firms operating at a large scale usually require more working capital than a business operating at a small scale. Large businesses also have more stock in inventory, which can take time to liquidate into cash and lock up capital for a long time, prompting a business to take a working capital loan to settle its accounts payable.
Conclusion: Effective Working Capital Management
A business fails when it does not have the capital to run its daily operations.
Whether one is a finance manager in a company or a small business owner, effective working capital management is one of the key ways to ensure the success of the venture.
While excessive working capital results in an unnecessary supply glut, less working capital as per the industry norms can lead to the requirement of working capital finance time and again.
Thus, financial institutions have launched several products designed specifically for the working capital needs of a business, be it in the form of working capital loans, invoice discounting, or an overdraft facility.
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FAQs
What is net working capital?
Net Working Capital is the difference between Current Assets and Current Liabilities of a business.
What are the factors affecting the working capital requirement of a company?
Some of the factors affecting the amount of working capital required by a company include business size, its operating cycle, its scale of operations, and the average period it takes for the business to receive payments for goods sold, among others.
What are the 4 main components of working capital?
The 4 main components of working capital are cash, accounts receivable, accounts payable, and inventory.
