Answer to Question #41863 in Economics of Enterprise for jayashree

Question

Explain the important determinants of the Working Capital needs of a firm. Can two firms with different Working Capital achieve the same amount of sales? If so, explain how.

Answer 1

Requirements Of working capital depend upon various factors such as nature of business, size of business, the flow of business activities. However, small organization relatively needs lesser working capital than the big business organization. Following are the factors which affect the working capital of a firm:

1. Size Of Business Working capital requirement of a firm is directly influenced by the size of its business operation. Big business organizations require more working capital than the small business organization. Therefore, the size of organization is one of the major determinants of working capital.

2. Nature Of Business Working capital requirement depends upon the nature of business carried by the firm. Normally, manufacturing industries and trading organizations need more working capital than in the service business organizations. A service sector does not require any amount of stock of goods. In service enterprises, there are less credit transactions. But in the manufacturing or trading firm, credit sales and advance related transactions are in large amount. So, they need more working capital.

3. Storage Time Or Processing Period Time needed for keeping the stock in store is called storage period. The amount of working capital is influenced by the storage period. If storage period is high, a firm should keep more quantity of goods in store and hence requires more working capital. Similarly, if the processing time is more, then more stock of goods must be held in store as work-in-progress.

4. Credit Period Credit period allowed to customers is also one of the major factors which influence the requirement of working capital. Longer credit period requires more investment in debtors and hence more working capital is needed.But, the firm which allows less credit period to customers needs less working capital.

5. Seasonal Requirement In certain business, raw material is not available throughout the year. Such business organizations have to buy raw material in bulk during the season to ensure an uninterrupted flow and process them during the entire year. Thus, a huge amount is blocked in the form of raw material inventories which gives rise to more working capital requirements.

6. Potential Growth Or Expansion Of Business If the business is to be extended in future, more working capital is required. More amount of working capital is required to meet the expansion need of business.

7. Changes In Price Level Change in price level also affects the working capital requirements. Generally, the rise in price
will require the firm to maintain large amount of working capital as more funds will be required to maintain the sale level of current assets.

8. Dividend Policy The dividend policy of the firm is an important determinant of working capital. The need for working capital can be met with the retained earning. If a firm retains more profit and distributes lower amount of dividend, it needs less working capital.

9. Access To Money Market If a firm has good access to capital market, it can raise loan from bank and financial institutions. It results in minimization of need of working capital.

10. Working Capital Cycle When the working capital cycle of a firm is long, it will require larger amount of working capital. But, if working capital cycle is short, it will need less working capital.

11. Operating Efficiency The operating efficiency of a firm also affects the firm's need of working capital. The operating efficiency of the firm results in optimum utilization of assets. The optimum utilization of assets in turn results in more fund release for working capital.
Two firms with different Working Capital can achieve the same amount of sales, in case if a company can achieve higher volume of sales with relatively small amount of working capital, it is an indication of the operating efficiency of the company.