Question

Explain the following factors affecting the working capital requirements of a business: 
(i) Credit allowed 
(ii) Production cycle 
(iii) Availability of raw material

Hint:

Working capital and dividend decisions are crucial to maintain liquidity and shareholder trust. Short cycles, raw material access, and stable cash flows keep the business running smoothly.

Answer 1

Factors Affecting the Working Capital Requirements of a Business:

(i) Credit Allowed:

Credit allowed refers to the practice of granting credit to customers, allowing them to make purchases and pay at a later date. When a business extends credit, it creates accounts receivable, which affects its working capital needs. The longer the credit period granted to customers, the more working capital is required to finance the unpaid receivables. Businesses with longer credit periods will need to maintain higher levels of working capital to bridge the gap between the sale of goods and the receipt of payment. Key points to consider:

• Increased receivables: Offering credit increases the amount of money tied up in receivables, which raises the need for additional working capital.
• Impact on cash flow: Extended credit terms can delay cash inflows, potentially leading to cash flow issues if not managed properly.
• Risk of bad debts: Granting credit may also result in bad debts, which further complicates the working capital requirements.

(ii) Production Cycle:

The production cycle is the time taken from the procurement of raw materials to the completion of the final product ready for sale. The length of the production cycle directly influences working capital requirements. A longer production cycle requires more working capital to cover the costs of raw materials, labor, and overheads during the production process. Factors to consider include:

• Inventory levels: Longer production cycles may result in higher inventory levels, which need to be financed through working capital.
• Cash conversion cycle: The production cycle affects the time taken for cash to be converted from raw material into finished goods and then into cash through sales.
• Capital tied up in production: A longer cycle means a greater amount of capital is tied up in the production process, requiring more working capital to keep operations running smoothly.

(iii) Availability of Raw Material:

The availability of raw material is another crucial factor affecting working capital requirements. When raw materials are readily available, a business can maintain steady production and control its working capital more efficiently. However, if raw materials are scarce or have to be purchased in bulk to secure a better price, businesses may need more working capital to purchase and store these materials. Important considerations include:

• Stock levels: Availability affects how much raw material needs to be stored, which in turn impacts inventory costs and working capital.
• Supplier terms: The payment terms with suppliers can influence the timing of cash outflows. If materials need to be paid for upfront or within a short period, more working capital may be needed.
• Price fluctuations: If raw material prices are volatile, businesses may need to adjust their working capital requirements to account for these price changes.