Working capital is the lifeline for any business. This results in management contributing a vast amount of time to ensuring that it is efficiently and effectively utilized. Therefore, it’s important for us to understand what affects working capital?
What is Working Capital?
Working capital represents your company’s current assets minus current liabilities. The importance of this measure will be apparent as you start a business since it can take some time to break even. Working capital ensures that your business holds an adequate amount of cash to pay for expenses and obligations as they fall due.
Effectively managing working capital involves considering its components such as inventory, trade receivables, trade payables, etc. Simply looking at current assets and current liabilities in aggregate will not ensure efficiency is achieved.
By effectively utilizing all components of working capital, you can establish a level that will prevent any adverse implications to business operations. Below are some factors that play a role in influencing the level of working capital required.
What Affects Working Capital?
1) Nature of Business:
The nature of business will play a fundamental role in the working capital requirement and is best demonstrated by comparing a manufacturing company to a retail company.
The manufacturing business will purchase raw materials and consumables, use in-house costs such as wages and overheads to convert these items into work in progress and finished goods. At any one time, the manufacturing company could be holding four types of inventory; raw material, consumables, work in progress, and finished goods.
Sales and purchases in the manufacturing company will be on credit, with the credit period heavily influenced by that particular manufacturing industry.
The consequences of a stock out in the manufacturing industry can be quite substantial as fixed costs such as rent and rates will still be incurred if production is halted. Therefore, it is quite common that such businesses will hold high levels of raw materials and consumables to prevent stock-outs from arising. Consequently, more working capital is required.
Retail businesses, on the other hand, tend to only hold one type of inventory, finished goods. These goods are typically purchased on credit and are quite often sold immediately after purchasing. In some cases, the sale is affected even before the purchase itself. As a result, lower levels of working capital is required.
Within the retail industry, different businesses will require different working capital levels depending on the nature of the business they are operating. A jeweler, for example, is likely to purchase inventory less frequently and hold the stock for longer periods as it is less likely to deteriorate. Their inventory levels will usually increase around Christmas and Valentine’s day.
A greengrocer, in comparison, will purchase their inventory more frequently while holding lower quantities due to deterioration which will adversely impact its value. The stock of certain items will increase around certain periods, for example, punkins at Halloween.
2) Permanent and Temporary Working Capital
A permanent investment in working capital will be required to ensure operational efficiency in meeting continuous sales demand throughout the year, while short-term or temporary working capital may necessary to satisfy seasonal demand.
Additional inventory may be needed to satisfy the increased demand for ice cream during the summer months. This increase in stock will contribute to a temporary increase in working capital for that period.
3) Business Cycle
Working capital can be greatly influenced by the business cycle. During a boom period, demand is likely to be high, thereby increasing the number of sales. As a result, this will lead to an increase in our working capital requirement.
In contrast, demand will decline during a recession, so too will sales, inventory levels, etc, thereby reducing the overall requirement for working capital during that period.
Competition within the market can significantly influence the level of working capital. Where competition is high, so too will be the requirement for working capital.
If a company has insufficient stock levels to satisfy demand, this may result in lost sales and a cost to the company of the contribution that they would have earned on that particular sale. If the product is not specialized and there is high competition, customers will go to a competitor. Therefore, a larger amount of inventory is often held to prevent lost sales to competitors.
Credit policies offered by our competition will further influence the requirement for working capital. To remain competitive and attractive to customers we need to consider credit terms offered by the competition while considering the needs of customers. As a result, this may lead to an increased level of credit customers, further increasing our level of working capital.
If competition is low and your product is of a specialized nature, the customer is likely to wait for their product. As a result, there will be less urgency on the requirement for working capital.
5) Value of Inventory
Working capital requirements will depend greatly on the value of the individual items of stock. Where inventory items are expensive, more time will be put towards the management of these items.
Where items of inventory are of relatively low value, less time will be given to managing these, as they tie up fewer resources. A jeweler, for example, may carry a larger quantity of batteries for watches and a low level of diamond rings.
6) Production Cycle
The production or operating cycle refers to the length of time that it takes to convert cash payable for net inputs into cash receivables for outputs. It covers the time span from purchase of raw materials to sale of those raw materials as finished goods.
For a manufacturing company, this period can be quite long. The cycle includes the number of days that the raw materials are held in inventory, in the manufacturing process, as finished goods in inventory before being sold to the customer, and the number of days that it takes for the customer to pay. This is then reduced by the credit period we receive from our supplier.
Operating cycle = raw material conversion period + work in progress conversion period + finished good conversion period + trade receivable conversion period – trade payable conversion period.
Operating cycle (retail company) = inventory conversion period + trade receivable conversion period – trade payable conversion period.
Carefully balancing the operating cycle is crucial to the success of a business. A long cycle will require a larger investment in working capital. Short cycles will need a lower level of working capital.
Having an unnecessarily long production cycle will tie up the company’s resources, thereby increasing costs associated with working capital while reducing overall profitability. A cycle that is too short may negatively impede production, contributing to poor quality and loss of sales.
7) Growth of Industry
Industries that are undergoing growth will require larger investments in working capital in comparison to industries that are relatively static.
Price changes will influence the working capital requirements of a business. During inflationary periods, when prices rise, the company will need a higher level of working capital as more funds will be required to maintain the previous scale of production and sales. Therefore, with the increasing rate of inflation, there is a corresponding increase in the working capital.
9) Supply of Raw Materials
Availability of raw materials will contribute vastly to the level of working capital required. Where raw materials are readily available, a business can maintain minimum inventory, therefore, less working capital is needed.
Lower inventory levels can be maintained where the business has established a good relationship with a supplier who has quick and effective distribution channels, enabling us to replenish stock quickly.
Where raw material supply is not certain or unpredictable, the company will hold a larger quantity of inventory in order to prevent stock-outs and ensure continuous production. Thereby, requiring larger levels of working capital.
10) Expected Business Growth
Additional working capital will be required to meet expansion needs where the business is expected to expand in the future in contrast to a business that is not expecting sufficient growth in sales, production, etc in the future.
11) Dividend Policy
Where a company retains more profit, distributing lower dividends, it will require lower levels of working capital which can be met with the retained earnings. As a result, the company’s dividend policy will influence working capital requirements.
12) Production policy
Changes in a company’s production policy will alter working capital levels. For example, if a company decides to split an order for 2000 units of their product into 2 batches of 1000 units, we would expect that splitting the production would reduce the requirement for working capital.
If a company has a steady production policy, whereby production is carried out evenly throughout the year to meet peak demand its inventory levels will be high during periods of lower sales demand. This accumulation of finished goods will necessitate the need for a higher level of working capital.
In contrast, if the production policy is to produce only when there is a demand then a lower amount of working capital will be needed during the slower season and high working capital when demand increases.
For more information on business finance, check out our articles on “4 factors to consider when choosing a source of finance” and “6 internal sources of finance for a business.“
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