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Factors Determining Working Capital

The amount of working capital that a firm would need is affected both, by the endogenous and exogenous factors. The endogenous factors are associated with the firm itself while the exogenous factors are attributable to economic,monetary and general business environment. Among the various factors, the following are important ones:

i.Endogenous Factors

Nature and Size of business: Enterprises fall into some broad categories depending on the nature of their business. For instance, a dairy farm engaged only in producing dairy products is a manufacturing firm while one engaged only in selling the products is a trading firm. The working capital requirements of an enterprise are basically related to the conduct of the business. The manufacturing firms have to invest substantially in working capital for purchasing raw material, paying wages and salaries, incurring expenses on fuel and power etc. The working capital requirement of dairy products manufacturer increases, if his firm is a manufacturing-cum-trading firm. In that case, besides manufacturing expenses, firm must incur marketing and sales expenses on items such as advertising, opening retail outlets,commission to sales agents etc. The working capital needs of solely trading dairyconcerns fall between the requirements of manufacturing firms and manufacturing-cum-trading firms. This is so because the shelf life of dairy products is short and hence trading firm does not carry large stock of the same. The size o  business also has an important impact on its working capital needs. Size may be measured in terms of the scale of operations. A firm with larger scale of operations will need more working capital than a small firm.

Production Cycle: The production cycle starts with the purchase of raw materials and is completed with the production of finished goods. If the manufacturing cycle involves a longer period, the need for working capital will be more, because an extended manufacturing time span means a larger tie-up of funds in inventories.For instance, the working capital need for manufacturing cheese is higher than that pasteurization of milk due to longer time required for manufacturing cheese. Besides,the normal length of the production cycle, the working capital requirement is also affected by any delays in the manufacturing process. A delay at any stage results in accumulation of work-in-process, thus enhancing the requirement of working capital.

Production Policy: In the case of certain lines of business, the demand for products is seasonal, for example, ice-cream will be purchased largely during summer season. If a firm follows a steady production policy, that is, continues to manufacture the product during off-season also, then there will be large accumulation of finished goods (inventories) during the off-season. The progressive accumulation of stock will naturally require an increasing amount of working capital which will remain tied-up till sales pick up during peak season.

However, it is not necessary that all firms follow a steady production policy. Firms whose physical facilities can be utilized for manufacturing a variety of products can have the advantage of diversified activities. Such firms manufacture a few products throughout the year, while certain other products are manufactured only in specific season e.g., a dairy plant, producing pasteurized milk throughout the year, produces ice-cream also in summers. Thus, production policies may differ from firm to firm depending upon the circumstances. Accordingly, the need for working capital will also vary.

Operating Efficiency: Operating efficiency means optimum utilization of resources by eliminating waste, improving co-ordination and a fuller utilization of existing resources etc. Management can contribute to a sound working capital position through efficiency of operations that increases the working capital turnover.

Credit Terms: You must have observed that not all the sales of a firm are cash sales, but often firms sell goods to its customers on credit. If the firm offers liberal credit terms to its customers, its working capital in form of receivables increases.A long collection period will generally mean tying of larger funds in debts and may even increase the chances of non-receipts of the money due (bad debts).

Though the credit terms granted to customers, largely depend upon the prevailing trade practices and changing economic conditions, yet it may be treated as an endogenous factor within the control of the firm. On the other hand, the credit terms available to the firm from its creditors is a exogenous factor affecting the working capital requirement of the firm. A firm enjoying liberal credit terms will need less working capital. The other exogenous factors influencing working capital needs are discussed as under.

ii. Exogenous Factors
Business Cycle: Business expands during periods of prosperity and declines during the period of depression. An upward swing in the economy during periods of prosperity leads to increased sales and hence higher working capital requirement to meet the greater demand for its product. The downswing phase of the business cycle will have exactly an opposite effect on the level of working capital requirements.

Price Level Changes: A general rise in the price level leads to higher requirement of working capital for carrying out existing level of business activity. However, in cases where firm increases the price of the product in proportion to general increase in price level, the working capital needs remain more or less unchanged.

Other Factors : There are some other factors like profit level, tax rates, dividend policy and depreciation policy which affect the working capital of a firm. Higher net profits contribute positively to working capital while higher tax rate decreases working capital. Similarly, a firm’s policy of paying higher dividends to its shareholders means decrease in cash available with the firm and thus reduces the firm’s working capital to that extent.

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