Determinants of Working Capital


Meaning of Working capital

Working capital refers to capital needed for financing the day-to-day operations of a business organization. It is an essential part of the business that covers the operating cost of the enterprise. Working capital is part of total business capital which needs to be maintained efficiently at all times for ensuring long-term continuity. This represents the amount businesses invest in current assets like raw materials, work-in-progress, bill receivable, bank balance, and sundry debtors. It is also termed as circulating or revolving capital which keeps on changing its form from one to another during the normal course of business, i.e., from cash to investors, investors to debt, and debt to cash again.

Working capital indicates the short-term financial position of the firm and is a measurer of its overall efficiency. It shows whether the company owns sufficient assets for covering its short-term debt and that is why working capital is in excess of current assets over the current liabilities. Every company must pay attention to efficient management of its working capital for enjoying better profits. Working capital is of two types which are Gross working capital and net working capital. Gross working capital represents the total value of the company’s current assets. Networking capital, on the other hand, represents the difference between current assets (gross working capital) and the current liabilities of the company.

Determinants of Working Capital

Various determinants of working capital can be well-understood from the points below: –

Nature of Business

Working capital requirements depend to a large extent on the nature of business activities carried out by the firm. Trading firms or manufacturing industries need a large number of funds as compared to service sector organizations. Manufacturing concerns need to invest a huge amount in fixed assets, raw materials, and finished products. Also, in manufacturing or trading firms, there is a large number of credit sales and advanced related transactions. Whereas, service firms do not need any stock of goods and have fewer credit transactions due to which they require less capital.

Size of Business

The size of business operations has a direct influence over the number of working capital requirements of the firm. Greater the size of business operations more will be working capital required and vice versa. Big companies require more working capital as companies than small ones because of their large-scale operations which need huge investments. In this manner, the size of the business is one of the major working capital determinants.

Storage time or processing period

The storage time of the period of processing also has a great impact on firm’s working capital need. The storage period reflects the time period for which stock needs to be kept in store. If a firm has a high storage period, it means more goods need to keep in store which needs more working capital. In the same way, if the processing period is high, then more stock of goods needs to be stored as work-in-progress by a firm requiring a huge amount of working capital. 

Use of manual labor

The extent to which a firm uses manual labor influence its working capital to large extent. Labor-intensive industries need more amount of working capital as compared to highly mechanized firms. The labor-intensive industries need to do payments to their workers periodically whereas, in mechanized ones, the firm does one-time investment in fixed assets and all activities go on with minimal labor involvement.

Credit policy of firm

The credit period allowed by the firm to its customers is also a major factor that influences working capital needs. If a firm gives a longer credit period to its customers, then more amount needs to invest in debts thereby requiring large working capital. But if the firm gives a less credit period, then less working capital will be needed.

Growth and expansion

The growth and expansion plans of business enterprises raise their needs for working capital. If the business is planning expansion in the future, then more investment needs to be done because of which working capital requirements get increased. 

Seasonal requirement

Many firms are engaged in a business where raw materials are not available throughout the year. They need to purchase raw material in bulk during the season and store it for ensuring interrupted operations throughout the year. In such cases, a large amount of capital is blocked in raw material which leads to higher working capital requirements.  

Profit margin and dividend policy

The profit margin and dividend policy of a firm determine the quantum of its working capital requirements. Companies following high net profit margins are easily able to contribute towards the working capital pool. More the net profit company earns, will be cash coming inwards which becomes a source of working capital. Also, the distribution of company’s earnings in the form of dividend results in a drain on cash resources which eventually bring down the overall working capital. In case, if management follows a conservative dividend policy, then the working capital position of the firm is strengthened and vice versa.

Technological changes

Technological changes or development in the area of production also act as a determinant of working capital. For technological up-gradation, the firm may need to install new machinery set up instead of the old system which requires a huge investment amount. The new system increases the efficiency of the firm and also utilizes less expensive raw material which benefits the organization on other hand.