10 FACTORS AFFECTING WORKING CAPITAL REQUIREMENTS OF A BUSINESS

J.O. EMMANUEL
0

Working capital is the capital of a business that is used to finance the day-to-day activities of the business.

It refers to the amount of money that a business can readily use for its daily activities.

10 factors affect the working capital requirements of a business, which are the nature of the business, the scale of operations, the business cycle, seasonal factors, the production cycle, the credit allowed, operating efficiency, availability of raw materials, credit received, and growth prospects.

1. Nature of business: A company's need for working capital depends on the nature of the business.

To understand how the nature of business affects working capital requirements, let us take the examples of a trading business and manufacturing business.

In a trading business, for instance, the company normally purchases goods from suppliers and resells them to customers without significantly processing or altering the goods.

This means that there is no difference between raw materials and finished goods for a trading business, and sales can be made almost immediately after receipt of the goods from the suppliers.

As a result, a trading company usually has lower working capital requirements.

On the other hand, in a manufacturing business, raw materials used in production must first be converted into finished goods before they can be sold.

This takes time and requires adequate funding for the raw materials, labor, and other resources used in the production process.

As a result, a manufacturing company often requires more working capital than a trading company.

2. Scale of operations: A company's need for working capital is also influenced by the size of its operations.

Generally, large-scale companies requires more working capital than small-scale companies because they require a lot more inventory of raw materials and finished goods to run their operations.

To illustrate, a large manufacturing company with multiple production lines and a high volume of sales will require a higher inventory of goods to support its operations.

The company also has to maintain a large list of debtors because the possibility of providing credit facilities to customers increases as the scale of production increases.

In contrast, a small manufacturing business will need less inventory because it has fewer production lines and a lower sales volume.

Hence, a small company will require lesser working capital when compared to a large manufacturing company.

3. Business cycle: This is another factor influencing the working capital requirements of a business.

During the period of economic boom, the economy is growing, and consumer demand for goods and services is generally rising.

As an increased demand, the sales and production of a company will increase so that a larger inventory of raw materials and finished goods is required to match the increase in sales brought about by the economic boom. 

As a result, the working capital requirement of the business will increase.

On the other side, during times of economic depression, economic growth is negative and there is typically a decline in demand for goods and services.

This will result in a decrease in the sales and production of a company as well as a reduction in the working capital requirement of the company.

4. Seasonal factors: The need for working capital can be significantly impacted by seasonality in business operations.

Many businesses experience seasonality in their operations, with periods of higher activity corresponding to peak season, and periods of lower activity corresponding to lean season.

During the peak season, when demand for goods or services is high, the company may need to increase production and maintain a higher level of inventory to meet the increase in demand.

As a result, the working capital requirement increases.

However, during the lean season, when demand for goods or services is low, the company may need to lower production and maintain a lower level of inventory to cope with reduced demand for its goods.

As a result, the working capital requirement decreases.

5. Production cycle: This refers to the time it takes for a company to transform raw materials into finished goods, and it can affect working capital requirements.

A company's need for working capital may rise if it has a longer production cycle since it may require more raw materials and other costs to support the process.

In contrast, a company with a shorter production cycle, on the other hand, will only need a small mount of working capital.

6. Credit allowed: A company may also offer credit facilities to its customers, depending on their creditworthiness and the level of competition it faces.

If a company has a liberal credit policy, it will attract more debtors, which will raise the amount of working capital required by the company since it will need additional funds to cover the cost of goods or services sold on credit until payment is received. 

By the same reasoning, a company with a strict credit policy will attract fewer debtors, decreasing the working capital requirements of the company.

7. Operating efficiency: This refers to how efficient a company is in carrying out its day-to-day business activities.

Generally speaking, companies with increased operational efficiency need less working capital.

For example, if a company can manage its raw materials efficiently, it will be able to manage operations with a smaller balance, and as a result, require little working capital.

Conversely, companies with lower operational efficiency typically need greater working capital.

For example, a poor debtors turnover ratio can tie up funds, and increase the working capital requirement.

8. Availability of raw materials: If raw materials are consistently available and can be obtained easily, the company may only need to maintain lower levels of inventory and low working capital.

As against this, if raw materials are not consistently available, the company may need to hold higher levels of inventory to ensure that it has sufficient raw materials for its operations. 

This will increase the company's working capital requirements.

9. Credit received: When a company grants credit to its customers, it allows them to make purchases now and pay for them at a later date. 

Similarly, when a company receives credit from its suppliers, it means that the suppliers are allowing the company to make purchases now and pay for them later.

If the suppliers of a company grant long-term credit, then the company has a longer period to pay back the suppliers for the goods or services it has purchased.

Therefore, the company can carry out its operations with less amount of working capital. 

On the contrary, if the suppliers of the company only grant short-term credit, then the company will have a shorter period to pay back the suppliers.

This means that the company will require extra working capital to make payments to its suppliers as they fall due.

10. Growth prospects: This is the potential for a company to grow and expand operations in the future.

If the growth prospect of a company is perceived to be high, it may require a larger amount of working capital so that it can meet the increase in production and support its growth whereas a company with limited growth potential will not need more working capital. 

Conclusions

To repeat, the 10 factors affecting the working capital requirements of a company are scale of operation, seasonal factors, nature of the business, production cycle, credit allowed, credit received, availability of raw materials, operating efficiency, growth prospects, and business cycle 

Tags

Post a Comment

0Comments

Post a Comment (0)