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8 Factors that Determine the Requirements of Working Capital

Published on Sept 19, 2022Updated on Dec 4, 2023

8 Factors that Determine the Requirements of Working Capital

What is a Working Capital?

The amount of working capital can make or break a business. It is essential to an enterprise like oxygen is to the body. A company can make do without profits but can only sustain itself for a short time with this approach. Working capital is the difference between what a business currently owns and owes. It is calculated with the following formula:

Working Capital = Current Assets – Current Liabilities

Estimating working capital requirements is essential in projecting an accurate amount. With a working capital loan, businesses can finance their short-term needs and expenses like raw materials, payments, bills, salaries, taxes, etc. This ensures streamlined operations for the coming months or financial year.

Types of Working Capital

Understanding the different types of working capital helps in better planning and resource allocation for the business. They are listed as follows:

Permanent Working Capital

It is the baseline amount of assets reserved by a company to run its operations during the year without difficulty. This includes the money needed to cover essential expenses, bills, etc. This capital depends on the company's size.

Regular Working Capital

A type of permanent working capital, regular working capital funds daily operations like material purchases, salaries, etc.

Reserve Margin Working Capital

As the name suggests, reserve margin working capital acts like a buffer during emergencies. The extra amount helps handle contingencies such as business depression, strikes, calamities, etc.

Variable Working Capital

It is also known as fluctuating capital. It is invested only for a specific time in the company. Additionally, this capital changes with the business volume or the amount of assets it has at a particular time.

Seasonal Variable Working Capital

This is seen in seasonal enterprises, which experience demand only during peak business seasons. Due to the sudden peak in demand, the need for extra finances increases quickly. Examples include raw cotton, sugarcane, dairy products, etc.

Special Variable Working Capital

Occasionally, a business may require extra funds to cater to exceptional circumstances or manage unplanned expenses. This is where special variable working capital compensates for these events.

Gross Working Capital

This category includes the total amount invested in current business holdings. It includes cash, inventory, receivables, securities, and short-term investments. It is an indicator of the financial position of the company.

Net Working Capital

Mathematically put, net working capital = current assets - current liabilities. If the net working capital is positive, it has enough funds to cover its expenses in the short term. Having adequate working capital is also a good indicator of a company's financial reliability. Therefore, more working capital translates to better opportunities to invest and grow in the long term.

Factors that Determine the Requirements of Working Capital

Every business enterprise, irrespective of its size, requires adequate working capital to keep running day-to-day operations smoothly. Lower working capital always results in lower business efficiency and market competitiveness. Many business enterprises fail in the market due to poor working capital management.

There are multiple factors influencing working capital requirements in a business, and they vary from business to business. The following are the top eight factors affecting working capital that are common in every business:

1. Sales

For any business, the size of the sale matters. To have a higher sales number, the business needs to maintain higher current assets in the form of inventory and cash at hand to sustain the operations and fulfill demand. Therefore, a business with a higher sales number requires higher regular working capital compared to a business with a lower sales turnover.

2. Length of the Operating Cycle

The operating cycle refers to the number of days it requires to acquire inventory, sell the inventory, and collect cash from the sale of inventory. A business with a longer operating cycle will have higher working capital requirements compared to a shorter operating cycle. For example, a chips manufacturer will have a shorter operating cycle compared to a real estate developer.

3. Inventory Management Policy

The working capital requirement also depends on the inventory management policy of the company. For example, if a company wants to stock all the raw materials before starting production, the working capital requirement will be very high as resources will get stuck until the operating cycle completes. But, if the company follows the Just in Time (JIT) inventory management policy, where materials are sourced just before the need arises, the working capital requirement will be much lower

4. Size of Business

The working capital requirements go up with the growth in the size of the business and scale of operations. A company that operates on a large scale with multiple manufacturing units spread across different regions will have higher working capital needs but will have better economics due to better bargaining power compared to small business units.

5. Credit Policy

The credit policy also dictates the working capital requirements of the business. A small business has to depend on deferred payments to drive sales and secure business orders. In case of missed payments from clients, it hurts the working capital requirements. Also, if you have raised any working capital loan in the past or have any short-term liabilities, its repayment will add to the working capital costs.

Naturally, in such a case working capital requirements will be higher. If supplies of raw materials are available on favorable terms and there are timely payments from clients, the requirement for working capital will be much less.

6. Seasonality of Business

Many businesses don’t generate enough sales throughout the year and are only season-specific. For example, businesses dealing in woolen garments, tourism industry, seasonal fruits exporters, etc. Such businesses experience a quick upsurge in sales that lasts a few weeks to months. During such a period, the business will require higher working capital requirements compared to the rest of the year to ensure competitiveness in the market.

7. Nature of Production Technologies

The nature of production technology incorporated in plants also impacts working capital needs. For example, if a plant uses a labor-intensive manufacturing process, the cost of wages will be higher compared to those plants that use automated production processes. A plant with an automated production process will require fewer workers, therefore the expenses like wages will be lower and there will be less wastage of resources, resulting in lower working capital requirements.

8. Contingencies

Risks in business also impact operational efficiency and working capital needs. Factors like inflation, and reduced demand due to changing trends in the market, impact the working capital requirements. All such factors increase the working capital requirement and the business needs to increase the contingency provisions to keep the business operations running.

How to Apply for Working Capital

While the application process may vary slightly for different lending institutions, most of them follow the guidelines below:

Step 1 - Check eligibility: You can quickly evaluate your eligibility for the loan by using online calculators.

Step 2 - Evaluate the key factors: Business size, production period, sales, periodicity, scope of activities, inventory management, and business commercials are important factors affecting your working capital requirements.

Step 3 - Acquire necessary documents: These include KYC documents, proof of ownership of the business, IT returns, etc.

Step 4 - Apply for the loan: We offer a seamless 100% online application process for a hassle-free start.

Conclusion

Depending on the nature of the business and other factors, the working capital requirements keep on changing. Therefore, the business needs a robust working capital management strategy so that the company operates efficiently using its current assets and current liabilities.

If there are any shortages, you can consider applying for a working capital loan with your lender. It will help you to maintain accounts payable, make short-term inventory purchases, and meet other short-term financial requirements.

Before applying for a working capital loan, check your eligibility using the business loan eligibility calculator to have an improved chance of loan approval. Also, you can use the business loan calculator to know the repayment structure and plan the size of the total working capital loan you can afford as per your business financials and cash flow.

* Please note that this article is for your knowledge only. Loans are disbursed at the sole discretion of SMFG India Credit. Final approval, loan terms, disbursal process, foreclosure charges and foreclosure process will be subject to SMFG India Credit's policy at the time of loan application. If you wish to know more about our products and services, please contact us

FAQs

What are the 4 key components of working capital?

Working capital involves four crucial aspects. These include:

  • Cash and cash equivalents
  • Accounts receivable
  • Accounts payable
  • Inventory

What are working capital and its types?

There are two types of working capital types: permanent and temporary. Other subtypes include:

  • Regular working capital
  • Reserve margin working capital
  • Seasonal variable working capital
  • Special variable working capital
  • Gross working capital
  • Net working capital

Why should you calculate your working capital requirement?

Estimating working capital requirements is essential because it helps business owners to:

  • Assess their financial health.
  • Plan for future growth of the company.
  • Maximise operations.
  • Plan better budgets.

What is the need for a working capital study?

A working capital study helps assess an organisation's present assets and liabilities to cater to its short-term financial needs. It helps a company prepare for unforeseen events and develop strategies to tackle them.

What is the working capital need ratio?

Also known as the current ratio, this financial metric measures a company's liquidity. It estimates a company's ability to meet its short-term financial requirements. It can be calculated with the formula,

Working Capital Needs Ratio = Current Assets / Current Liabilities

What are the five elements of working capital management?

Ensuring a proper balance among the five elements of working capital helps maintain smooth operations and explore growth opportunities.

  • Cash management
  • Receivables management
  • Inventory management
  • Accounts Payable Management
  • Short-term financing

How does dividend policy affect the working capital of a company?

A company's dividend policy can impact its working capital in two ways. First, borrowing money for short-term needs becomes problematic when the company pays dividends from its savings. Second, paying dividends can reduce the company's cash savings, making it more challenging to cover its short-term expenses.

Give the calculation of working capital management?

The working capital can be measured with the formula,

Working capital = current assets - current liabilities, where current assets include cash, inventory, accounts receivable, etc., and current liabilities include accrued expenses, accounts payable, and short-term debt.

Can working capital be negative?

Yes. When the company has more current liabilities than current assets, a negative working capital balance is possible. This is an indicator of the financial distress of the company.

How does working capital affect valuation?

The status of a company's working capital plays a vital role in its valuation. A substantial amount of working capital assures the investors of the company's capacity to fulfil its short-term obligations. A weak working capital, on the other hand, has a negative impact.

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