Factors Affecting Working Capital Requirements

As earlier mentioned, sufficient working capital is needed for the management of a business. Too much capital is not beneficial to an enterprise. As much as possible, an enterprise should strive towards achieving a commensurate working capital. There are no set rules or formula to determine the working capital required by an organisation. However, the following factors influence the working capital requirements of a firm (Jain and Khan, 1990):

Nature of Business

The nature of business determines the requirements of the working capital. Some companies require little working capital while others require intensive working capital for instance, retail businesses and construction firms need to invest substantially in working capital and less amount in fixed assets. In contrast, parastatal such as PHCN has little need for working capital but needs to invest abundantly in fixed assets.

Sales and Demand Conditions

The availability of funds, type of products and sales environment will determine the extent of working capital requirement. The classes of customers, price and quality of products, determine the level of sales and therefore, the amount of investment in finished products and debtors. Some products have high degree of seasonal variability, for example, household products are sold purely on cash basis depending on the demand for the product.

Manufacturing Process

The stages and period of production (from the input of raw materials to finished goods) also affect the requirement for working capital. For example, the manufacturing of products such as soap and detergents may be produced within a day, the sales proceeds could be realised immediately while manufacturing of products such as cars can take months, sales can be gradual, and most times, they might be on credits.

 Credit Policy

Credit terms granted by a company to its customers may depend on the norms of the industry in which the company operates. For instance, pharmaceutical companies deal mainly in cash while hoteliers may give about two weeks or more for corporate guest to settle their bills.

Credit Granted By Suppliers

A company will need less working capital if liberal credit terms are available to it. For instance, a company that enjoys less credit period than it does for its customers would have high need for short-term funds than a firm, which enjoys greater credit period from its suppliers than it, gives its customers. The availability of credits from banks also influences the working capital requirements. A firm, which can get bank credit easily on favourable conditions, will operate with less working capital than firms without such facility will.

Price Level Changes

Price is relevant to purchases of material, manufacturing of finished and eventual sales. The increasing shift in price level makes the function of the financial manager more difficult. Generally, rising price levels will compel a firm to maintain higher amount of working capital. Same level of current assets will need to be increased when prices are rising, most especially stock level, however, debtors needs to be reduced during this period because the fall in the value of money. Nevertheless, when prices are generally falling, companies are advised to invest less in stock and more in debtors.

The enumerated factors are cardinal in deciding the amount of working capital, the proportion of working capital to fixed capital and the period of operations. An astute businessperson that understands these factors will be able to manage working capital effectively towards the achievement of the overall business objective.

SELF-ASSESMENT EXERCISE 3

Enumerate and explain the various factors affecting working capital requirements of any business enterprise of your choice.