Determinants of Working Capital
Determinants of working capital
Determinants of Working Capital
The subject of what are the determinants of working capital is a very important issue in finance. A company's capital structure is critically dependent on three determinants of working capital.
These determinants are the length of time the company has been in operation, the value of assets held by the company, and the price of assets owned by the company.
All of these determinants have important influences on the company's ability to finance its activities and its ability to obtain working capital advances.
Some of the determinants of working capital management are:1. Nature of business: varies with the financial cycle.
Different industries have different characteristics, including changes in relative prices of commodities, economic expansion and contraction, and sources of new capital. Companies can adopt either qualitative or quantitative methods for identifying potential risk factors, although both are quite complex.
There is no simple relationship between the price level changes at any particular time and the firm's working capital requirements. In most industries, there is often a lag between price level changes and firmwide activity.
This means that firms must plan for changes in relative prices of key inputs (commodities, fixed equipment, and inventory, etc. ), for periods when market conditions are conducive for short-term price changes and periods when they may be unfavorable (including price level changes that exceed average economic cycles).
The second determinant of working capital requirements is the amount of non-working assets. Public utility assets are those assets used in public utilities such as water, sewer, electricity, gas, etc.
Some of these may be fixed assets or variable assets such as accounts receivable and accrued expenses. The largest portion of public utility assets is fixed, while the smaller portion is variable. While the value of fixed assets decreases with the changing economy, the value of variable assets increases with the increasing economy.
The third determinant of working capital investment is the state of credit policy of the bank. A bank's credit policy essentially decides on the availability of short-term financing.
It also determines the cost of borrowing funds (risk-premium) that banks charge their customers. Credit policy determinants can include the level of interest rates (APR), the rate at which banks purchase credit (interest rate), the minimum amount of credit that banks are allowed to borrow (minimum balance), reserve funds, the amount of credit that a bank is authorized to borrow at any given point (credit spread), reserve growth, and whether the bank targets a specific percentage of its assets (risk premium). In addition to these determinants, credit policy determinants influence the cost and duration of capital.
As the name implies, this category includes the four determinants of working capital. The fourth determinant is the state of the manufacturing policy of a bank.
Manufacturing policy refers to the overall operating profit level of a manufacturing concern. An important determinant of manufacturing policy is the supply of manufacturing personnel, raw materials, and intermediate goods needed in the production process.
The fifth and final determinant of working capital is the total cost of doing business. The total cost of doing business includes purchasing raw materials, paying labor and other operating costs, and making payments to customers.
While banking systems do not usually consider it, direct manufacturing costs, including overhead expenses, are included in the total cost of doing business. These direct costs are all costs that affect production and delivery before customer sales. While it would be easy to consider only the company's operating costs as part of the total cost of doing business, the inclusion of indirect and direct manufacturing costs into the equation infuses a large measure of economic influence into the firm's profit margin.
As an alternative to the traditional monetary method of calculating the solvency of manufacturing concerns, banking systems rely on various financial ratios such as the gross profit margin, assets, net worth, and networking capital. These ratios help determine the solvency of a concern. Although these ratios are commonly referred to as P/E ratios, they represent value creation rather than return on investment. While banks calculate these ratios in order to provide a standard definition of their institution's ability to generate profits, they fail to consider the role that public utilities play in the formula for their calculation. In short, the banking system often under-estimates the effects of public utilities on profits and, as a result, under-estimates the solvency of manufacturing concerns.