This section is from the book "Business Finance", by William Henry Lough. Also available from Amazon: Business Finance, A Practical Study of Financial Management in Private Business Concerns.
How is it possible to calculate in advance how much working capital will be required, and thus keep on the safe side in providing capital funds? It is not possible to give an exact formula for answering this question, but an approximate answer in any given case may be reached.
First of all, it is clear that the proportion of working capital in some lines of business is far greater than in other lines. This may be illustrated by two extreme cases. Telephone companies necessarily have large sums invested in wiring, poles, central offices, and other equipment, but after a complete telephone plant has been installed in a community the running expenses consist simply in maintenance and in the salaries of officers and employees and are comparatively light. It is the custom for telephone companies to render bills for their services once a month in advance; consequently, all the money which is required for running expenses from month to month is provided before the expenses are really incurred. Evidently there is no necessity in this instance for working capital, because the current receipts may safely be depended upon to take care of the current outgo.
On the other hand, let us take a retail store which occupies rented quarters. The only fixed assets required will consist of store furniture and equipment; all the other assets, including the stocks of merchandise, the accounts receivable, and the cash, are "current" or "working." The greater portion of the capital that must be invested in such an enterprise, will consist of working capital. This is true of practically all trading enterprises, and is particularly true of financial enterprises. Banks must keep all, or nearly all, of their assets in such a form as to be converted into cash almost at a moment's notice.
We may consider, therefore, as the first factor which determines the requirements of working capital, the general nature of the business. If the business consists merely of leasing real estate, providing facilities for transportation, and the like, all or nearly all of the investment will be in fixed forms. If the business is manufacturing, then a relatively small proportion will consist of working capital. If it is trading or financing, the chief requirement will be for working capital.
A second factor obviously is the volume of business. Generally speaking, the necessity for working capital - except in the first class of business above mentioned - will vary in proportion to the volume of sales. However, this statement assumes that the other factors mentioned below are uniform in their operation. Making the assumption that methods, expenses, and terms of buying and selling goods and of producing the goods are standardized, then we may safely say that a 50% increase in output and sales will necessitate a proportionate increase in working capital.
But these general remarks as to the nature and volume of business are serviceable chiefly in forestalling any misunderstanding of what follows.
The practical considerations that require thought and are helpful in making estimates of working capital are:
3. Terms of sale.
5. Facilities for converting working assets into cash.
6. Seasonal variations in business.
The process of making proper allowances for all these factors and of calculating in advance the volume of working capital that will be needed is of so much importance that a separate chapter is devoted to this subject (Chapter XVII).