Q&A - What factors determine the amount of working capital in a business?
Many factors affect the level of working capital in a firm. It is important to remember that different industries have different working capital profiles, reflecting their methods of doing business and what they are producing and selling.
• Businesses with a lot of cash sales and few credit sales should have minimal trade debtors. Supermarkets are good examples of this
• Businesses that exist to trade in completed products will only have finished goods in stock. Compare this with manufacturers who will also have to maintain stocks of raw materials and work-in-progress.
• Some finished goods, notably foodstuffs, have to be sold within a limited period because of their perishable nature.
• Larger businesses may be able to use their bargaining strength as customers to obtain more favourable, extended credit terms from suppliers. By contrast, smaller companies, particularly those that have recently started trading (and do not have a track record of credit worthiness) may be required to pay their suppliers immediately.
• Some businesses will receive their monies at certain times of the year, although they may incur expenses throughout the year at a fairly consistent level. This is often known as “seasonality” of cash flow. For example, travel agents have peak sales in the weeks immediately following Christmas.
Working capital needs also fluctuate during the year
The amount of funds tied up in working capital would not typically be a constant figure throughout the year. Only in the most unusual of businesses would there be a constant need for working capital funding. For most businesses there would be weekly fluctuations.
Many businesses operate in industries that have seasonal changes in demand. This means that sales, stocks, debtors, etc. would be at higher levels at some predictable times of the year than at others.
The amount of working capital held by a business depends on a variety of factors: for example:
Need to hold inventories
Some businesses need to hold substantial inventories to meet customer needs – e.g. retailers and distributors
Production lead time
A product that is made and sold within a short time (e.g. fresh food) requires much less inventory than one where the production process takes a long time (e.g. production of mature cheese!)
Businesses that successfully implement lean production techniques find that they need to hold significantly less inventory
Expected credit period by customers
In some industries it is expected that a long credit period can be taken before trade debtors need to settle their invoices – which means that higher working capital is required
Effectiveness of the credit control function
A poorly managed credit control department will allow customers to take too much credit and take too long to settle their bills – which will mean higher trade debtors and higher working capital
Credit period offered by suppliers
The longer the credit offered by suppliers, the better for cash flow and working capital.
It follows from the above that the main causes of working capital (and therefore cash flow) problems are:
• Poor control of inventories (stocks)
• Poor control of receivables (trade debtors)
• Ineffective use of payables (trade creditors)
• Poor cash flow forecasting
• Unexpected events