Determinants (Factors Affecting) Working Capital

The amount of working capital a firm needs is not the same for every business — it depends on a number of factors. Two firms in the same industry can have very different working capital requirements. A student should be able to explain the main determinants and, more importantly, the direction in which each pushes the requirement.

1. Nature of business. A trading or manufacturing business needs large working capital because it must hold stock and give credit. A service business (or a public utility that sells for cash) needs relatively little, as it holds little or no stock.

2. Scale of operations. A larger business handling a greater volume of transactions needs proportionally more working capital to finance its larger stock, receivables and running expenses.

3. Length of the operating cycle. The longer the time between paying for stock and collecting cash from customers, the more working capital is tied up in the cycle. A firm with a short operating cycle needs less.

4. Credit policy. A liberal credit policy (allowing customers a long time to pay) increases debtors and therefore increases working capital. Conversely, buying on generous credit from suppliers reduces the firm's own working capital requirement.

5. Seasonality of business. A highly seasonal business needs a large amount of temporary working capital in its busy season and much less in the off-season.

6. Business cycle / market conditions. During a boom, higher production and sales increase the need for working capital; during a slump, requirements fall.

7. Availability of raw material. If raw material is scarce or seasonal, a firm must stock up heavily, tying up more working capital; if supply is smooth and reliable, less stock — and less working capital — is needed.

8. Rate of stock turnover. A firm that sells its stock quickly (high turnover) recovers its investment fast and needs less working capital; a firm with slow-moving stock needs more.

9. Growth and expansion. A growing firm needs additional working capital to support higher levels of stock, receivables and operations before the extra profits actually arrive.

10. Price level changes. Rising prices mean the same physical volume of stock and receivables costs more, increasing the working capital requirement.

| Factor | Effect on working capital requirement |

|---|---| …