DETERMINANTS OF WORKING CAPITAL - Accounts and Finance for Managers

Determinants of Working Capital in Financial Management

Following are the major determinants of the working capital:

General nature of Business: The nature of the business should be considered for the determination of working capital only to the tune of i) cash nature of business ii) sale of services rather than commodities:
These are things considered only on the basis of stock, book volume of debts and so on.

Production cycle: The need of the working capital is determined on the basis of duration of the production cycle. The time duration taken by the manufacturing process should be considered from the stage of raw materials to the stage of finished goods. If the duration is lengthier may require the firm to keep more amount of working capital to meet out the requirements and vice versa.

Business cycle: The cycle of the business should be relatively considered for the need of working capital. The upswing of the business cycle requires the business venture to invest more amount of working capital due more volume of sales, results out of huge volume of stock, book debts and so on. During the downswing of the business require the business to have only lesser volume of working capital due lesser volume of business and so on.

Production policy: The working capital requirement is determined on the basis of production policy of the firm. Normally the production policy of the firm is classified on the basis of two methodologies:

  1. The firm produces the goods then and there to the tune of immediate needs of the market. This may require the firm to meet adversities due to lack of working capital to meet out, due to in adequate planning. During the peak season, it requires enormous working capital which may disturb working conditions of the business venture.
  2. The steady production policy by considering the futuristic demands, which will not disturb the long-term prospects of the business venture due to effective planning.

Credit policy: The credit policy of the firm is another determinant for the determination of the working capital. There are two different credit policies viz liberal and stringent credit policies

  1. Liberal credit policy: The liberal credit policy may lead to have greater volume of book debts, greater credit period, huge amount required for the built of stock; require the firm to have greater amount of working capital
  2. Stringent credit policy: Would not require that much of working capital like the earlier segment.

Growth and Expansion: The growth and expansion prospects of the firm should be appropriately determined in order to identify the volume of working capital required during the future, unless otherwise that will badly affect the future development of the firm.

Acute shortage of the raw materials supply: If the shortage of raw materials is acute, the firm is required to keep sufficient volume of working capital to have smooth flow of production process without any interruptions. In such cases the firm should have additional volume of working capital not only to avoid interruptions during the production process due lack of supply of raw materials, but also to enjoy greater trade discounts during the bulk purchase in order to bring down the purchase cost of the raw materials.

Net profit: It is one of the major sources of working capital and practically speaking it is one of the sources of cash from operations. To maintain the liquidity, the net profit earning capacity should be maintained forever.

Dividend policy: The cash dividend payment leads to greater amount of cash outflows which are more essential to the value of the firm to be maintained. The value of the firm could also be alternately maintained by either through the declaration of bond dividend or stock dividend or property dividend. The later specified methodologies facilitate the firm to postpone the cash out flow which normally evade the immediate cash requirement.

Depreciation policy: The depreciation policy of the firm not only facilitates to bring down the taxable liability but also brings down the profit which enhances the liquidity of the firm on the other side.

Price level changes: The price level changes require the firm to keep more amount of working capital to go hand in hand with the price changes which normally affect the firm's liquidity position. During the periods of inflation, the firm is required to anticipate the price level changes which drastically affect the working capital position of the firm.

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