The determinants of working capital are items that have a direct impact on the amount invested in current assets and current liabilities. Managers like to keep a close watch over these factors, since working capital can absorb a large part of the funding that an organization has at its disposal. Accordingly, managers are always trying to adjust the manner in which operations are run in order to pare back on the working capital investment.
There are a number of determinants of working capital, which include the following:
- Credit policy. If a business offers easy credit terms to its customers, the company is investing in accounts receivable that may be outstanding for a long time. This investment can be reduced by tightening the credit policy, but doing so may drive away some customers.
- Growth rate. If a business is growing at a rapid rate, it is likely increasing its investments in receivables and inventory. Unless profits are extremely high, it is unlikely that the entity can generate sufficient cash to pay for these receivables and inventory, resulting in a steady increase in working capital. Conversely, if a business is shrinking, its working capital requirements will also decline, which spins off excess cash.
- Payables payment terms. If a company can negotiate longer payment terms with its suppliers, it can reduce the amount of investment needed in working capital, essentially by obtaining a free loan from its suppliers. Conversely, short payment terms reduce this source of cash, which increases the working capital balance.
- Production process flow. If a company estimates its production needs, what it manufactures will likely vary somewhat from actual demand, resulting in an excess amount of inventory on hand. Conversely, a just-in-time system produces goods only to order, so the investment in inventory is reduced.
- Seasonality. If a company sells most of its goods at one time of the year, it may need to build its inventory asset in advance of the selling season. This investment in inventory can be reduced by outsourcing work or paying overtime to manufacture goods at the last minute.