Page 31 - DCOM505_WORKING_CAPITAL_MANAGEMENT

Working Capital Management

Notes Production Cycle

Another factor which has a bearing on the quantum of working capital is the production cycle.
The term ‘production or manufacturing cycle’ refers to the time involved in the manufacture of
goods. It covers the time-span between the procurement of raw materials and the completion of
the manufacturing process leading to the production of finished goods. Funds have to be
necessarily tied up during the process of manufacture, necessitating enhanced working capital.
In other words, there is some time gap before raw materials become finished goods. To sustain
such activities the need for working capital is obvious. The longer the time-span (i.e. the
production cycle), the larger will be the tied-up funds and, therefore, the larger is the working
capital needed and vice-versa. There are enterprises which, due to the nature of business, have a
short operating cycle. A distillery, which has an ageing process, has generally to make a relatively
heavy investment in inventory. The other extreme is provided by a bakery. The bakeries sell
their products in short intervals and have a very high inventory turnover. The investment in
inventory and, consequently, working capital is not very large.
Further, even within the same group of industries, the operating cycle may be different due to
technological considerations. For economy in working capital, that process should be selected
which has a shorter manufacturing process. Having selected a particular process of manufacture,
steps should be taken to ensure that the cycle is completed in the expected time. This underlines
the need for effective organisation and coordination at all levels of the enterprise. Appropriate
policies concerning terms of credit for raw materials and other supplies can help in reducing
working capital requirements. Often, companies manufacturing heavy machinery and equipment
minimise the investment in inventory or working capital by requiring advance payment from
customers as work proceeds against orders. Thus, a part of the financial burden relating to die
manufacturing cycle time is passed on to others.

Business Cycle

The working capital requirements are also determined by the nature of the business cycle.
Business fluctuations lead to cyclical and seasonal changes which, in turn, cause a shift in the
working capital position, particularly for temporary working capital requirements. The variations
in business conditions may be in two directions:
1. Upward phase when boom conditions prevail, and
2. Downswing phase when the economic activity is marked by a decline.

During the upswing of business activity, the need for working capital is likely to grow to cover
the lag between increased sales and receipt of cash as well as to finance purchases of additional
material to cater to the expansion of the level of activity. Additional funds may lie required to
invest in plant and machinery to meet the increased demand. The downswing phase of the
business cycle has exactly an opposite effect on the level of working capital requirement. The
decline in the economy is associated with a fall in the volume of sales which, in turn, leads to a
fall in the level of inventories and book debts. The need for working capital in recessionary
conditions is bound to decline. In brief, business fluctuations influence the size of working
capital mainly through the effect on inventories. The response of inventory to business cycles is
mild or violent according to nature of the business cycle.

Production Policy

The quantum of working capital is also determined by production policy. In case of certain lines
of business, the demand for products is seasonal, that is, they are purchased during certain
months of the year. What kind of production policy should be followed in such cases? There are
two options open to such enterprises: either they confine their production only to periods when

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