A company’s working capital is the money it has available to pay for day-to-day expenses. It is a measure of a company’s financial health and is used to give an indication of its ability to pay short-term debts and meet other financial obligations. A company’s working capital can be positive or negative, but a negative working capital indicates that a company is in financial trouble.
Working capital is a measure of a company’s short-term liquidity and its ability to pay debts as they come due. It is the difference between a company’s current assets and current liabilities. A company with a high working capital is typically more liquid and has an easier time paying its debts than a company with a low working capital. Working capital is important because it allows a company to pay for its day-to-day expenses, such as inventory, salaries, and utilities.
Factors Affecting Working Capital
The working capital can be affected by a number of factors, including the price of raw materials, the cost of labor, and the amount of debt that the business has. A company’s management team must constantly monitor these and other factors.
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Nature of Business
In any business, Working Capital requirements depend on the nature of business. For some businesses, like Manufacturing, working capital requirements are very high as they need to maintain a certain level of inventory. Other businesses, like Service companies have low working capital requirements as they do not need to keep any inventory. In general, though, all businesses need some level of working capital to maintain operations. Wholesalers generally require more working capital than retail shops. This is because wholesalers have to maintain large stock levels and often sell goods on credit.
Scale of Operations
Large businesses need to maintain more inventory, debtors, and other assets than small businesses, and so they generally require more working capital. Small businesses typically have less inventory and receivables than larger businesses, so they need less money to finance their operations.
Some goods are demanded throughout the year while others have seasonal demand. Seasonal demand can be affected by many factors, such as weather, holidays, and cultural traditions. The businesses that produces goods which have uniform demand the whole year need little working capital because their production and sale are continuous. Such enterprises are always in demand because they produce goods which people need all year round. Some goods have seasonal demand but are produced almost the whole year so that their supply is readily available when demanded. Such enterprises require large amounts of working capital.
In any business, the working capital requirements vary according to the stage of business cycle the company is in. For example, during an economic expansion, businesses are generally more optimistic and expand their operations. This usually results in increased working capital needs as businesses invest in inventory and receivables to support the growth. However, during a recession, businesses may cut back on production and inventory, which can lead to decreased working capital needs.
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If a company is using labour intensive techniques of production, then more working capital is required. This is because labour is a major cost in production and the more labour intensive the production process, the higher the costs. If a company is using a machine-intensive technique of production, it will require less working capital. Machine-intensive techniques generally require less working capital because the machines take on a larger share of the work. This leaves less for the workers to do, and therefore requires fewer workers and less money to pay them.
If suppliers of raw materials are giving long term credit then company can manage with less amount of working capital. If suppliers are giving only short period credit then company will require more working capital to make payments to creditors.
A company’s credit policy is the set of guidelines it uses to determine whether to extend credit to a customer and, if so, how much credit to extend. A company following a liberal credit policy will require more working capital than one with a strict or short-term credit policy because it will be extending credit to more customers and/or extending credit for longer periods of time.
Availability of Raw Materials
It is easier for firms to manage with less working capital when raw materials and inputs are easily available, as the need to maintain stocks of raw materials is reduced or not needed at all.
Operating efficiency is a measure of how well a company uses its labor and other resources to produce goods and services. A company with high operating efficiency requires less working capital than a company with low operating efficiency. This is because high operating efficiency leads to lower production costs, which in turn leads to higher profits and lower working capital requirements.
Level of Competition
The amount of working capital a business requires is directly related to the level of competition it faces. A business with less competition or a monopoly position will require less working capital as it can dictate terms according to its own requirements. This is because there is no need to match the prices or terms offered by competitors.