FINANCIAL MANAGEMENT & COST ACCOUNTING

Module 6. Working capital management

Lesson 31
FACTORS AFFECTING WORKING CAPITAL

31.1 Factors Affecting Working Capital

The working capital requirements of an enterprise are basically related to the conduct of the business. Enterprises fall into some broad categories depending on the nature'-of their business. For instance public utilities have certain features which have a bearing on their working capital needs: The two relevant features are: (i) the cash nature of business. i.e., cash sale and (ii) sale of services rather than commodities. In view of these features they do not maintain big inventories and have, therefore, probably the least requirement of working capital. At the other extreme are trading and financial enterprises.

The nature of the business is such that they have to maintain a sufficient amount of cash. They have necessarily to invest proportionately large amounts in working capital. The manufacturing enterprises fall in a sense between these two extremes. The industrial concerns require fairly large amounts of working capital though it varies from industry to industry depending on their asset structure. The proportion of current assets to total assets measures the relative requirements of working capital of various industries.

31.2 Operating Cycle

Operating Cycle and Cash Cycle

The investment in working is influence by the following events in the operating cycle of the firm:

• Purchase of raw materials
• Payment for raw materials
• Manufacture of goods
• Sale of finished goods
• Collection of cash for sales

Exhibit 31.1 depicts these events on the cash flow line. The firm begins with the purchase of raw materials which are paid for after a delay which represents the accounts payable period. The firm converts the raw materials into finished goods is the inventory period. Customers pay their bills some time after the sales. The period that elapses between the date of sales and the date of collection of receivables is the accounts payable period (debt period).

The time that elapses between the purchase of raw materials and the collection of cash for sales is referred to as the operating cycle, whereas the time length between the payment for raw material purchases and the collection of cash for sales is referred to as the Casy Cycle. The operating cycle is the sum of the inventory period and the accounts receivable period, whereas the cash cycle is equal to the operating cycle less the accounts payable period.

From the financial statements of the firm, we can estimate the inventory period, the accounts receivable period, and the accounts payable period.

Exhibit 31.1 Operating and Cash Cycle

Exhibit 31.2 provides the relevant information for Horizon Limited. Based on this information, we calculate several things :

31.2.1.1 Production policies

The production policies pursued by the management have a significant effect on the requirements of working capital of the business. The production schedule has a great Influence on the level of inventories. The decision of the management regarding automation etc will also have its effect on working capital requirements. In case of labour-intensive industries the working capital requirements will be more, which in case of highly automatic plants, the requirements of ' long-term funds will be more.

31.2.1.2 Business fluctuation

Most firms experience seasonal and cyclical fluctuations in the demand for their products and services. These business variations affect the working capital requirement, specially the temporary working capital requirements of the firm. When there is an upward swing in the economy, sales will increase; correspondingly, the firm’s investment in inventories and book debts will also increase. Under boom, additional investment in fixed assets may be made by some firms to increase their productive capacity. This act of the firms will require further additions of working capital. To meet their requirements of funds for fixed assets and current assets under boom period, firms generally resort to substantial borrowing. On the other hand, when there is a decline in the economy sales will fall and consequently, levels of inventories and book debts will also .fall. Under recessionary conditions, firms try to reduce their short-term borrowings.

Seasonal fluctuations not only affect working capital requirements but also create production problems for the firm. During periods of peak demand increasing production may be expensive for the firm. Similarly it will be more expensive during slack periods when the firm has to sustain its working force and physical facilities without adequate production- and sales. A firm may thus follow a policy of steady production,' Irrespective of seasonal changes in order to utilize its resources to the fullest extent. Such a policy will mean accumulation of inventories during the off season and their quick disposal during the peak season.

The increasing level of inventories during the slack season will require increasing funds to be tied up in the working capital for some months. Unlike cyclical fluctuations, seasonal fluctuations generally conform to a steady pattern. Therefore, financial arrangements for seasonal working capital requirements can be made in advance. However, the financial plan or arrangement should be flexible enough to take care of some abrupt seasonal fluctuations.

31.2.1.3 Credit policy

A company, which allows liberal credits to its customers, may have higher sales but will need more working capital as compared to a company which has efficient debt collection machinery and observing strict credit terms. This is because in the case of the former company a substantial amount of its funds will get tied up in its sundry debtors. The working capital requirements can also be affected by the Credit facilities enjoyed by the company. A company enjoying liberal credit facilities from its suppliers will need lower amount of working capital as compared to a company which does not enjoy such credit facilities.

31.2.1.4 Growth and expansion

As a company grows, it is logical to expect that a large amount of working capital will be required. It is of course difficult to determine precisely the relationship between the growth in the volume of business of a company and the increase in its working capital. The composition of working capital in a growing company also shifts with economic circumstances and corporate practices. Other things being equal growth industries require more working capita) than those that are static. The critical fact; however is that the need for increased working capital funds does not follow the growth in business activities but precedes it. Advance planning of working capital is therefore, a continuing necessity for a growing concern. Or else the company may have substantial earnings but little cash.

31.2.1.5 Fluctuations of supply

Certain companies have to obtain and maintain large reserves of raw materials due to their irregular sales and intermittent supply. This is particularly true in case of companies requiring special kind of raw materials available only from one or two sources. In such a case large quantity of raw materials has to be kept in store to avoid any possibility of the production process coming to a dead halt. Thus, the working capital requirements in case of such industries would be large.