January 26, 2022

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Six determinants of Working Capital

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In this article, we will examine six determinants of an entity’s investments in working capital. These factors include the nature of business, market and demand conditions, technology and manufacturing policy, credit policy, availability of credit from suppliers, and operating efficiency.

Nature of Business

The nature of a firm business affects its working capital needs. The amount of WC required by trading firms is different from that of manufacturing entities. More so, the more durable the company’s product is, the less the working capital is needed. In addition, if the entity cost of making the product available to customers is higher, it means more working capital finance will be needed.

Market and Demand Condition

The nature of the market and demand conditions have some influence on the entity’s WC. A growth firm will need more working capital finance to establish new markets in different countries. Also, products with seasonal and cyclical demands will require more WC during those periods.

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Technology and Manufacturing policy

This is for manufacturing firms. And the working capital strength is determined by the manufacturing cycle. A manufacturing firm with a short manufacturing cycle will need less WC, than that of a longer cycle. If the entity plans to use technology, it should use one with the shortest manufacturing cycle. This will help reduce the fund needed for WC.

Credit Policy

The types of credit policy practiced by an entity influenced WC. A lenient policy will make an entity have huge debtors. And the inability to recover the debts can lead to a lack of funds to meet other obligations. Therefore, leading to the need for more WC borrowings. However, a good credit policy will make more funds available to the entity and reduce its need for WC from external sources.

Availability of Credit from Suppliers

The willingness of suppliers to sell on credit to the entity determines WC. If the supplier has a stringent credit policy, and the firm can rely on banks to give loans on favorable terms, then it will be able to finance its working capital needs.

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Operating Efficiency

Though, it may be easy for some entities to get funds to finance their WC needs. However, failure on operating efficiency will erode the borrowed money and negatively affect its cash conversion cycle. Operating efficiency entails controlling operating expenses and utilizing fixed and current assets in a less costly manner. Doing so will leave extra cash in the firm’s vault to meet other daily obligations.

Conclusion

The aforementioned six determinants of working capital are not exhaustive. The business chief financial officer will need to observe properly other factors that may influence the entity’s WC. Knowing this will enable him or her to determine the business WC requirements.

Source: I.M Pandey

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