Working Capital Management: Factors, Methods, and Impact

Posted on Sep 8, 2025 in Economy

Determinants of Working Capital

The factors influencing a firm’s working capital decisions can be classified into two main groups: internal factors and external factors.

Internal Factors Affecting Working Capital

These factors originate from within the business operations and strategic choices:

  • Nature and size of the business
  • Firm’s product policy
  • Firm’s credit policy
  • Dividend policy
  • Access to money and capital markets
  • Growth and expansion of business
  • Profit margin
  • Operating efficiency of the firm
  • Coordination of activities within the firm

External Factors Influencing Working Capital

These factors are outside the direct control of the firm but significantly impact working capital needs:

  • Business fluctuations (economic cycles)
  • Changes in technology
  • Import policy
  • Infrastructural facilities
  • Taxation policy

Measuring Working Capital Requirements

There are three primary methods for assessing a firm’s working capital requirements:

1. Percent of Sales Method

Based on past experience, a certain percentage of sales can be used to determine the required quantum of working capital. This method assumes a direct, proportional relationship between sales and working capital needs.

2. Regression Analysis Method

This method involves plotting the relationship between sales and working capital (and its various components) on a scatter diagram. The average percentage of sales over a past period (e.g., 5 years) can then be ascertained and used as the working capital requirement. A similar exercise can be carried out at the beginning of each year. This method is suitable for both simple and complex financial situations.

3. Operating Cycle Method

Also known as the working capital cycle, the operating cycle represents the total time gap between the purchase of raw materials and the receipt of cash from debtors. This method focuses on the duration funds are tied up in current assets.

Advantages of Adequate Working Capital

Working capital is the lifeblood and nerve center of a business. Just as the circulation of blood is essential for maintaining life in the human body, adequate working capital is crucial for the smooth running of a business. No business can operate successfully without a sufficient amount of working capital. The main advantages of maintaining an adequate amount of working capital are:

  1. Business Solvency: Adequate working capital helps maintain the solvency of the business by ensuring an uninterrupted production flow and the ability to meet short-term obligations.
  2. Enhanced Goodwill: Sufficient working capital enables a business to make prompt payments to suppliers and creditors, thereby creating and maintaining strong goodwill and a positive reputation.
  3. Easier Access to Loans: A concern with adequate working capital, high solvency, and good credit standing can secure loans from banks and other financial institutions on easy and favorable terms.
  4. Cash Discounts: Adequate working capital allows a business to avail cash discounts on purchases, significantly reducing procurement costs.
  5. Regular Supply of Raw Materials: Sufficient working capital ensures a consistent supply of raw materials, leading to continuous production and avoiding costly disruptions.
  6. Timely Payments: A company with ample working capital can make regular payments of salaries, wages, and other day-to-day commitments. This boosts employee morale, increases efficiency, reduces wastage and costs, and ultimately enhances production and profits.
  7. Exploiting Favorable Market Conditions: Only businesses with adequate working capital can capitalize on favorable market conditions, such as purchasing requirements in bulk when prices are low or holding inventories for higher prices.
  8. Ability to Face Crises: Adequate working capital enables a concern to navigate business crises and emergencies, such as economic depressions, when there is typically significant pressure on working capital.
  9. Quick and Regular Return on Investments: Investors seek quick and regular returns. Sufficient working capital allows a firm to pay consistent dividends, gaining investor confidence and creating a favorable market for raising additional funds in the future.
  10. High Morale and Efficiency: Adequacy of working capital fosters an environment of security, confidence, and high morale, contributing to overall operational efficiency within the business.

Managing Working Capital: Avoiding Excess and Shortages

Every business must maintain an optimal level of working capital for smooth operations. Both excessive (redundant) and inadequate (shortage) working capital positions are detrimental to a business. However, an inadequacy of working capital is generally considered more dangerous for a firm’s survival and growth.

Disadvantages of Excessive Working Capital

While seemingly safe, an abundance of working capital beyond what is needed can lead to several problems:

  1. Idle Funds: Excessive working capital means idle funds that earn no profits for the business, leading to a suboptimal rate of return on investments.
  2. Inventory Accumulation: Redundant working capital can encourage unnecessary purchasing and accumulation of inventories, increasing the risks of theft, waste, and losses.
  3. Defective Credit Policy: It may imply excessive debtors and a defective credit policy, potentially causing a higher incidence of bad debts.
  4. Operational Inefficiency: Excessive working capital can result in overall inefficiency within the organization due to a lack of urgency in managing resources.
  5. Strained Bank Relations: When there is excessive working capital, the firm might not fully utilize credit facilities, potentially straining relations with banks and other financial institutions.
  6. Decreased Share Value: A low rate of return on investments, often a consequence of excessive working capital, can lead to a fall in the value of the company’s shares.
  7. Speculative Transactions: Redundant working capital might tempt management to engage in speculative transactions, which carry higher risks.

Dangers of Inadequate Working Capital

A shortage of working capital poses significant threats to a business’s stability and growth:

  1. Loss of Reputation and Credit: A concern with inadequate working capital cannot pay its short-term liabilities on time, leading to a loss of reputation and difficulty in securing favorable credit facilities.
  2. Missed Discounts: The inability to purchase requirements in bulk means missing out on valuable cash discounts, increasing operational costs.
  3. Missed Opportunities: It becomes challenging for the firm to exploit favorable market conditions or undertake profitable projects due to a lack of necessary liquid funds.
  4. Operational Inefficiencies: The firm struggles to cover day-to-day operational expenses, which creates inefficiencies, increases costs, and ultimately reduces business profits.
  5. Underutilization of Fixed Assets: Fixed assets may not be utilized efficiently due to the non-availability of liquid funds required for raw materials, labor, and other operational needs.
  6. Reduced Return on Investments: A shortage of working capital can lead to a fall in the overall rate of return on investments, impacting investor confidence and future funding prospects.