How To Determine Working Capital Requirements In 2022?
While running an organisation, knowing and understanding the working capital requirement is imperative. Owners and financial executors must clearly understand the working capital requirement to efficiently manage financial inflows and outflows and ensure growth. This piece thoroughly discusses working capital requirements, ways to determine the need and related things. Read along for a better understanding!
Working Capital Requirement (WCR) – A Brief Introduction
Before delving deep into various aspects of working capital requirements, it is essential to know about working capital in detail. Working capital refers to the difference between current assets (such as accounts receivable, value of inventory etc.) and current liabilities (outstanding bills, i.e. accounts payable, dividends payable to investors etc.).
Therefore, working capital requirement refers to the money needed to cover the financial gap between disbursements (payment to suppliers) and receipts (payment from customers). In short, WCR shows the amount/financial resource required to cover the production cycle costs, debt repayments, and meet operational expenses.
Now that individuals know about the working capital requirement, let’s focus on factors that determine the same.
Major Factors That Determine Working Capital Requirements
Here is a list of factors that decide the working capital requirements of a business:
- Nature Of Business
One of the major factors that help determine the working capital requirements is the nature of business. For example, trading firms need increased working capital than manufacturing companies/organisations.
Trading firms demand a high amount of goods to stock, thus requiring a large amount of working capital in comparison to manufacturing companies. The value of current assets in both trading and manufacturing companies is 80%-90% of the total value of the asset.
Similarly, businesses that deal with public utility undertakings, such as electricity, water supply or railway services need a small amount of working capital as they provide cash sales and supply services and not products. That is why these businesses do not have a large amount of money locked in inventories and a list of receivables.
- Nature Of Production Technology
Working capital requirement highly depends on the nature of production technology. If an organisation works with a large labour workforce, then that organisation has to pay wages, conduct training programs, organise various activities, hence needing more working capital.
On the other hand, organisations whose production process is highly technology-based need not pay wages to large employees; thus, the working capital requirement is also less. However, technology-based production processes have servicing/maintenance costs, which are usually not a monthly requirement; hence need for a surplus fund is not a concern for organisations.
- Terms Of Credit
Term of credit is another important determinant factor of working capital requirement, which refers to the time given to the customer to return the money. The term of credit may vary from one organisation to another.
For example, a firm provides 20 days credit while another firm has set the credit period at 90 days. In the case of the latter organisation, working capital requirements will be more as the inflow of money will take a substantial time.
On the other hand, some organisations may provide extended credit facilities to certain reliable customers. Here, businesses must understand that no matter the facility offered, it will increase working capital requirements. This is because debtors will have an extended balance period, raising working capital.
However, the terms of credit can work differently if businesses get the supply of raw material at an extended term of credit. If companies get the supply in the longer term, they will have to repay after a relatively long period. Thus, the working capital requirement will also decrease.
To determine working capital requirements, business persons must know the size of sales. Organisations willing to increase sales volume must primarily focus on maintaining current assets. Doing so will help the organisation acquire a position where it can maintain a balanced ratio of current assets to annual sales.
Thus, the turnover increases, reducing the operating cycle. When a business has a reduced operating cycle, working capital requirement also reduces and vice versa.
- Length Of Operating Cycle
In a business, the conversion of cash occurs through the different stages, which starts from raw material to semi-processed goods and follows a step-by-step process like finished products, sales of these products, debtors, bills receivables. Finally, all these processes end with the conversion of cash. The whole process takes some time, which is known as the ‘length of operating cycle’ in business terms. Remember, the greater the operating cycle, the more working capital is required.
For instance, a business that is into heavy engineering demands increased working capital than that of a cotton spinning mill. Thus, it is clear that depending on the length of the operating cycle, the demand also varies.
- Seasonal Variations
Working capital requirement of a regular or all-season business varies on seasonal operations. Here, business persons can easily understand that their organisations require more working capital to manage all business activities and ensure smooth business operations during the peak seasons.
Thus, businesses that rely on seasonal operations must accumulate the necessary funds to purchase raw materials and stock up inventories. Here, if an organisation thoroughly assesses market demand, manufactures and sells accordingly, they can get back the money locked up in the inventory. Remember, in the case of seasonal businesses, the working capital requirement is higher during peak season and lower in slack season.
- Working Capital Cycle
As stated earlier, the working capital cycle starts with buying off raw materials in the manufacturing industries and ends with getting cash from the sales of finished products. Working capital cycle refers to the time required to convert current assets into current liabilities (purchased stocks, raw materials), and then into cash.
To determine working capital requirements, business persons need to focus on the speed of each working capital cycle. In the case of a long cycle, money gets tied up for a long time. On the other hand, in the case of short cycles, money is almost readily available as businesses get cash faster, thus can remain agile.
Businesses that have long working capital cycles may face issues managing required cash to cover day-to-day operations and short-term obligations. Here, they can opt for various funding options like Invoice Discounting.
Invoice Discounting helps businesses free up cash tied in unpaid invoices for the offered goods and services. Reputed cash flow solution providers like KredX offer hassle-free Invoice Discounting where eligible businesses can get instant cash by keeping unpaid invoices as collateral.
Method To Calculate Working Capital Requirement
The formula that businesses use to calculate working capital is as follows,
Working Capital= Current Assets – Current Liabilities
On the other hand, to calculate working capital requirement, businesses have to follow the below-mentioned formula,
Net Working Capital Requirement= Inventory + Accounts Receivable – Accounts Payable
The formula of working capital requirement helps businesses to manage their finances efficiently.
To manage a business efficiently, individuals need to understand the working capital requirement thoroughly. One can easily learn about the cash/fund requirements by assessing the factors that determine the same. When the elements are known, one can get a definite monetary figure via calculation. This helps businesses plan an increase in sales without having a cash shortage to purchase raw materials and ensure smooth business operations and growth.