In this article we will discuss about the working capital requirements of a business.
Factors Determining Working Capital Requirement:
There is no set of universally applicable rules to ascertain working capital needs of a business organization.
The factors which influence the need level are discussed below:
a. Nature of business:
If we look at the balance sheet of any trading organization, we find major part of the resources are deployed on current assets, particularly stock-in-trade. Whereas in case of a transport organization, major part of funds would be locked-up in fixed assets like motor vehicles, spares and work shed etc. and the working capital component would be negligible.
The service organizations need lesser working capital than trading and financial organizations. Therefore, the requirement of working capital depends upon the nature of business carried by the organization.
b. Manufacturing cycle:
Time span required for conversion of raw materials into finished goods is a block period. The period, in reality, extends a little before and after the WIP. This cycle determines the need of working capital. In case of industries with long manufacturing process or production cycle, more funds are required for working capital.
The industries involved in quick conversion of raw materials into finished units or having lesser production cycle requires lesser amount of working capital.
c. Production process:
In case of labour intensive industries high working capital is needed. But in case of capital intensive industries the production process is faster and it requires lesser amount of working capital due to lesser conversion costs.
d. Business cycle:
This is another factor which determines the need level. Barring exceptional cases, there are variations in the demand for goods/services handled by any organization.
Economic boom or recession etc., have their influence on the transactions and consequently on the quantum of working capital required. More working capital is needed during peak or boom conditions. But in case of economic recession or low inflationary conditions, the company requires low or moderate working capital.
e. Seasonal variations:
Variation apart, seasonality factor creates production or even storage problem. Mustard and many other oil seeds are Rabi crops. These are to be purchased in a season to ensure continuous operation of oil plant. Further there are woolen garments which have demand during winter only. But manufacturing operation has to be conducted during the whole year resulting in working capital blockage during off season.
f. Scale of operations:
Operational level determines working capital demand during a given period. Higher the scale, higher will be the need for working capital. However, pace of sales turnover (quick or slow) is another factor. Quick turnover calls for lesser investment in inventory, while low turnover rate necessitates larger investment.
g. Inventory policy:
The traditional production systems generate more stocks of finished goods and high levels of raw materials and WIP stocks are maintained and the stock holding period is also more.
In such cases more working capital is needed. The adoption of JIT, supply chain management, vendor management will drastically reduce the levels of raw materials, WIP and finished goods stocks and, therefore, less amount of funds are invested in inventory.
h. Credit policy:
Credit policy of the business organization includes to whom, when and to what extent credit may be allowed. Amount of money locked-up in account receivables has its impact on working capital. The liberal credit period and follow-up procedures will increase the investment in debtors balances and simultaneously increase the working capital requirement, than concerns resorting to strict credit and collection procedures.
i. Accessibility to credit:
Creditworthiness is the precondition for assured accessibility to credit. Accessibility in banks depends on the flow of credit i.e., the level of working capital.
j. Business standing:
In case of newly established concerns the materials are required to be purchased in cash and the sales are to be made on credit basis. Such new concerns require high levels of working capital. But the established companies can negotiate for credit terms with suppliers and sell the products at lesser credit period to customers. Therefore, it requires less working capital than concerns with lesser business standing.
k. Growth of business:
Growth and diversification of business call for larger volume of working fund. The need for increased working capital does not follow the growth of business operations but precedes it. Working capital need is in fact assessed in advance in reference to the business plan.
l. Market conditions:
In a buyers’ market i.e. the market with fierce competition, the companies are forced to sell on credit, with liberal credit and collection policies. This increases the level of investment in working capital due to increased debtors balances and its administration costs. But if the sellers’ market prevails, the quick disposal of stocks, high percentage of cash sales, strict credit and collection policies etc., reduces the need for working capital.
m. Supply situation:
In easy and stable supply situation, no contingency plan is necessary and precautionary steps in inventory investment can be avoided. But in case of supply uncertainties, lead time may be longer necessitating larger basic inventory, higher carrying cost and working capital need for the purpose. Aggressive approach cannot be adopted in such situation.
n. Environment factors:
Political stability brings in stability in money market and trading world. Things mostly go smooth. Risk ventures are possible with enhanced need for working capital finance. Similarly, availability of local infrastructure facilities like road, transport, storage and market etc., influence business and working capital need as well.
Working Capital Requirement in Seasonal Industries:
In the seasonal industries, the level of working capital requirement will not be similar all through the year. In times of off-season, the working capital requirement and the levels of investment in current assets and liabilities are very low. During season, the firm’s requirement of working capital is at peak level. Let us look at the ‘sugar industry’.
The crushing season in a year will remain for 5 to 6 months time. During the season the plant is expected to work at full capacity with triple shift working and the requirement of stocks of raw material is very high and resultant increase in stocks of sugar. The requirements for payment of labour, expenses and maintenance is also higher.
There will not be immediate sale of sugar and finished stock inventory would be much higher. After the completion of the crushing season, the plant will be closed and only upkeep and maintenance of plant will be incurred and the level of current assets and current liabilities comes down and the working capital requirement would be very low.
For efficient management of working capital, the Finance manager should be able to properly estimate the season and off-season requirements of working capital.
For this he has to take the following precautions:
(a) Preparation of projected cash flow statement showing the cash flow for peak season, normal season and off-season requirements.
(b) Make proper arrangements with the banks and other sources of finance to meet the short- term needs of season.
(c) Make proper arrangement for meeting the contingencies of higher level requirement than the projected levels of requirement.
(d) Proper and careful assessment of working capital requirements for the season and offseason requirement.
(e) Care to be taken to reduce the level of investments in current assets after the season is completed.
The Finance manager of a seasonal industry should be extra cautious while assessment of working capital for the firm.
Working Capital Requirement during Periods of Inflation:
One of the objectives of working capital management is to determine and maintain the optimum level of investment in current assets for increase of return on capital employed.
While determination of working capital requirements, moderate inflation rate can be ignored, but high rates of inflation will be considered otherwise, wrong setting of working capital level will hamper the smooth flow of working and profitability of the concern.
When the inflation rate is high, it will have its direct impact on the requirement of working capital as explained below:
(a) Inflation will cause to show the turnover figure at higher level even if there is no increase in the quantity of sales. The higher the sales means the higher levels of balances in receivables.
(b) Inflation will result in increase of raw material prices and hike in payment for expenses and as a result, increase in balances of trade creditors and creditors for expenses.
(c) Increase in valuation of closing stocks result in showing higher profits but without its realization into cash causing the firm to pay higher tax, dividends and bonus. This will lead the firm in serious problems of funds shortage and firm may unable to meet its short-term and long-term obligations.
(d) Increase in investments in current assets means the increase in requirement of working capital without corresponding increase in sales or profitability of the firm.
Keeping in view of the above, the Finance manager should be very careful about the impact of inflation in assessment of working capital requirements and its management.
Working Capital Requirement in Industries with Shift Working:
If the firm which is presently running in single shift, plans to go for working in double or triple shift the following factors should be considered while assessing the working capital requirements of the firm:
Item Impact on working capital investment levels:
1. Raw material stock:
a. Working in double/triple shift means requirement of raw materials will be doubled/tripled. It increases the safety stock levels, and revision of economic order quantity levels. The need for increased levels of stock simultaneously increases the need for working capital.
b. Increase in material requirement may call for bulk purchasing and it reduces the cost per unit of raw material consumed.
2. Work-in-progress stock:
a. The shift working will not increase the level of work-in-progress stock, since the WIP generated in one shift will be converted into finished units in next shift and so on.
b. The variable cost per unit will remain same except increase in labour cost due to payment of night shift allowance.
c. Fixed cost per unit reduces due to dispersion of it over more number of units produced.
d. The overall investment in WIP stock will remain same even if plant is operating on shift basis.
3. Finished goods stock:
a. Due to increase in production, the stock of finished goods will increase and simultaneously the requirement for working capital will also increase.
b. The variable cost per unit will not change except in case of savings for bulk purchases and extra labour cost for night shift working.
c. The fixed cost per unit is reduced drastically.
d. The overall reduction in cost of production may reduce the funds requirement.
4. Sundry creditors:
a. The increase in demand calls for increase in production, through shift working. The increased operational level increases the credit sales which increases debtors, and require more working capital than before.
b. The increased production may require to extend liberal credit period than before and may require to offer discounts for sale of additional units.
c. The increase in debtors balances increases the cost of administration of debtors balances and opportunity cost of funds invested in debtors.
5. Sundry creditors:
The shift working needs for more quantity of raw materials, stores and consumables. The level of trade credit increases, due to bulk purchases, the purchase price and credit period to be renegotiated with the suppliers. The benefit of cash discounts can also be taken to the advantage. The overall cost per unit of raw material consumption may be reduced due to increased purchase of raw materials.
The Finance manager should reassess the working capital requirements if the change is contemplated from single shift operation to double or triple shift.