Estimating Working Capital Requirement: Top 5 Methods ......Illustration 2: The following are the extracts from the balance sheet of a company as on 30.6.2008. Compute the additional

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The following points highlight the top five methods for estimating working

capital requirements, i.e., 1. Percentage of Sales Method 2. Regression

Analysis Method 3. Cash Forecasting Method 4. Operating Cycle Method 5.

Projected Balance Sheet Method.

Estimating Working Capital Requirement Method # 1. Percentage of Sales

Method:

This method of estimating working capital requirements is based on the assumption

that the level of working capital for any firm is directly related to its sales value. If past

experience indicates a stable relationship between the amount of sales and working

capital, then this basis may be used to determine the requirements of working capital

for future period.

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Thus, if sales for the year 2007 amounted to Rs 30,00,000 and working capital required

was Rs 6,00,000; the requirement of working capital for the year 2008 on an estimated

sales of Rs 40,00,000 shall be Rs 8,00,000; i.e. 20% of Rs 40,00,000.

The individual items of current assets and current liabilities can also be estimated on

the basis of the past experience as a percentage of sales. This method is simple to

understand and easy to operate but it cannot be applied in all cases because the direct

relationship between sales and working capital may not be established.

Illustration 1:

The following information has been provided by a company for the year

ended 30.6.2008:


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Illustration 2:

The following are the extracts from the balance sheet of a company as on

30.6.2008. Compute the additional working capital required by the

company for the year ending 30.6.2009.

Estimating Working Capital Requirement Method # 2. Regression Analysis

Method (Average Relationship between Sales and Working Capital):

This method of forecasting working capital requirements is based upon the statistical

technique of estimating or predicting the unknown value of a dependent variable from

the known value of an independent variable. It is the measure of the average

relationship between two or more variables, i.e.; sales and working capital, in terms of

the original units of the data.

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The relationships between sales and working capital are represented by the

equation:

Illustration 3:

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The sales and working capital figures of Suvidha Ltd. For a period of 5 years

are given as follows:


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Estimating Working Capital Requirement Method # 3. Cash Forecasting

Method:

This method of estimating working capital requirements involves forecasting of cash

receipts and disbursements during a future period of time. Cash forecast will include all

possible sources from which cash will be received and the channels in which payments

are to be made so that a consolidated cash position is determined.

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This method is similar to the preparation of a cash budget. The excess of receipts over

payments represents surplus of cash and the excess of payments over receipts causes

deficit of cash or the amount of working capital required.

The following illustration explains the cash forecasting method of

estimating working capital requirements:

Illustration 4:

Texas Manufacturing Company Ltd. is to start production on 1st January, 2009. The

prime cost of a unit is expected to be Rs 40 out of which Rs 16 is for materials and Rs 24

for labour. In addition, variable expenses per unit are expected to be 7 & Rs 8 and fixed

expenses per month Rs 30,000.

Payment for materials is to be made in the month following the purchases. One-third of

sales will be for cash and the rest on credit for settlement in the following month.

Expenses are payable in the month in which they are incurred. The selling price is fixed

at Rs 80 per unit.

The numbers of units manufactured and sold are expected to be as under:


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Estimating Working Capital Requirement Method # 4. Operating Cycle

Method:

This method of estimating working capital requirements is based upon the operating

cycle concept of working capital. The cycle starts with the purchase of raw material and

other resources and ends with the realization of cash from the sale of finished goods.

It involves purchase of raw materials and stores, its conversion into stock of finished

goods through work-in-process with progressive increment of labour and service costs,

conversion of finished stock into sales, debtors and receivables, realization of cash and

this cycle continues again from cash to purchase of raw material and so on. The

speed/time duration required to complete one cycle determines the requirement of

working capital – longer the period of cycle, larger is the requirement of working capital

and vice-versa.

The requirements of working capital be estimated as follows:


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For proper computation of working capital under this method, a detailed analysis is

made for each individual component of working capital.

The value of each individual item of current assets and current liabilities is

determined on the basis of estimated sales or budgeted production or

activity level as follows:

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(a) Stock of Raw Material:

The amount of working capital funds to be invested in holding stock of raw

material can be estimated on the basis of budgeted units of production,

estimated cost of raw material per unit and the average duration for which

the raw material is held in stock by using the following formula:

(Note. 360 days in a year may. be assumed in place of 365 to simplify calculations in

some cases)

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(b) Stock of Work-in-Process:

In manufacturing/processing industries the production is carried on continuous basis.

At the end of the period, some work remains incomplete even though all or some

expenses have been incurred, this work is known as work-in-progress or partly

completed or semi-finished goods. The work-in-process consists of direct material,

direct labour and production overheads locked up in these semi-finished goods.

The amount of funds estimated to be invested in work-in-process may be

computed as:

Note:

(i) 360 days a year may be assumed to simplify calculations.

(ii) In the absence of information about stage of completion of WIP with regard to

material labour and overheads, 100% of material cost, and 50% of labour and

production overheads cost may be assumed as the estimated cost of work-in-process.

(iii) In case cash cost approach’ is followed for estimation of working capital, then

depreciation should be excluded from production overheads while calculating cost of

work-in-process. However, under the total approach, depreciation is also included.

(c) Stock of Finished Goods:

The amount of funds to be invested in holding stock of finished goods can

be estimated on the basis of annual budgeted units of production,


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estimated cost of production per unit and the average holding period of

finished goods stock by using the following formula:

Note:

(i) Cost of production consist of 100% of material, labour and production overheads

costs.

(ii) Under the total cost approach, depreciation is included in the cost of goods

produced.

However, depreciation is to be excluded under the cash cost approach.

(d) Investment in Debtors/Receivables. When the sales are made by a firm on cash

basis, the amount is realized immediately and no funds are blocked for after sale period.

However, in case of credit sales, there is a time lag between sales and realization of cash.

Thus, funds are to be invested in receivables, i.e. debtors and bills receivables.

However, actual amount of funds locked up in receivables is only to the extent of cost of

sales and not the actual sales which include profit. It would, therefore, be more

appropriate to ascertain the amount of funds to be invested in debtors/receivables at

cost of sales and not the selling price. But in case, total approach is followed for

estimation of working capital then receivables may be computed on the basis of selling

price.

Note:

(i) Cost of sales = Cost of goods produced/sold + Office and administrative overheads +

Selling and distribution overheads

(ii) Selling price per unit should be considered in place of cost of sales per unit in case

total approach is to be followed for estimation of working capital. Under the total

approach, all costs including depreciation and profit margin are included.


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(e) Cash and Bank Balance:

Cash is one of the current assets of a business. It is needed at all times to keep the

business going. A business firm has to always keep sufficient cash to meet its

obligations. Thus, a minimum desired cash and bank balance to be maintained by a firm

should be considered as an important component of current assets while estimating the

working capital requirements.

(f) Prepaid Expenses:

Some of the expenses like wages, manufacturing overheads, office and administrative

expenses and selling and distribution expenses etc. may have to be paid in advance.

Such prepayment of expenses should also be estimated while computing working capital

requirements of a firm.

(g) Trade Creditors:

The term trade creditor refers to the creditors for purchase of raw material,

consumables, stores etc. The suppliers of goods, generally, extend some period of credit

in the normal course of business. The trade credit arrangement of a firm with its

suppliers is an important source of short-term finance. It reduces the amount of net

working capital required by a firm.

The amount of funds to be provided by creditors can be estimated as

follows:

(h) Creditors for Wages and Other Expenses:

Wages and salaries are usually paid on monthly, fortnightly or weekly basis for the

services already rendered by employees. The longer the payment – period, the greater is

the amount of current liability towards employees or the funds provided by them. In the

same manner, other expenses may also have to be paid after the lag of a certain period.

The amount of such accrued or outstanding expenses reduces the level of net working

capital requirements of a firm.

The creditors for wages and other overheads may be computed as follows:


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Note:

(i) The creditors for wages and each of the overheads may be calculated separately.

(ii) In case of selling overheads, budgeted annual sales in units should be considered in

place of budgeted production units,

(i) Advanced Received. Sometimes a payment may be received in advance along-with

purchase order, such advances reduce the amount of net working capital required by a

firm.

Factors Requiring Consideration While Estimating Working Capital:

The estimation of working capital requirement is not an easy task and a large number of

factors have to be considered before starting this exercise.

For a manufacturing organisation, the following factors have to be taken

into consideration while making an estimate of working capital

requirements:

From the total amount blocked in current assets estimated on the basis of the first seven

items given above, the total of the current liabilities, i.e., the last three items, is

deducted to find out the requirements of working capital.

In case of purely trading concerns, points 1, 2 and 3 would not arise but all other factors

from points 4 to 10 are to be taken into consideration. In order to provide for

contingencies, some extra amount generally calculated as a fixed percentage of the


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working capital may be added as a margin of safety.

Suggested proformas for estimation of working capital requirements are

given as below:

1. For a Trading Concern :

Proforma:

Note:

Profits should be ignored while calculating working capital requirements as funds

provided by profits may or may not be used as working capital.

2. For a Manufacturing Concern:


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Notes:

Profits should be generally ignored while calculating working capital requirements for

the following reasons:

(a) Profits may or may not be used as working capital.

(b) Even if profits are to be used for working capital it has to be reduced by the amount

of income-tax, drawings, dividend paid, etc.

3. Columnar Form:

An alternative proforma for estimation of working capital requirements in

columnar form is given below:

Approaches to Estimation of Working Capital Requirements:


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While studying the valuation of each individual item of current assets or

current liabilities under the operating cycle method, that there are two

approaches which are followed in the estimation of working capital

requirements:

(a) Total Approach

(b) Cash Cost Approach

(a) Total Approach:

Under this approach of estimation of working capital requirements, all costs including

depreciation and profit margin are included. Thus, production overhead inclusive of

depreciation is considered for calculation of the cost of work-in-progress. In the same

manner, cost of goods produced includes depreciation. Further, the computation of

funds invested in debtors is done on the basis of selling price including profit margin.

(b) Cash Cost Approach:

Under this approach, the amount of working capital is estimated on the basis of only

cash costs incurred. Thus, depreciation being non-cash is excluded while calculating the

cost of work-in-process, cost of goods produced and cost of goods sold. In the same

manner, debtors are computed on the basis of cash cost of sales excluding profit margin.

Estimating Working Capital Requirement Method # 5. Projected Balance

Sheet Method:

Under this method, projected balance sheet for future date is prepared by forecasting of

assets and liabilities by following any of the methods stated above. The excess of

estimated total current assets over estimated current liabilities, as shown in the

projected balance sheet, is computed to indicate the estimated amount of working

capital required.

Illustration 5:

Prepare an estimate of working capital requirement from the following

information of a trading concern:


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Illustration 6:

From the following details you are required to make an assessment of the

average amount of working capital requirement of AB Ltd.:


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Illustration 7:

ABC Ltd. sells its products on a gross profit of 20% on sales.

The following information is extracted from its annual accounts for the

year ended 31st March 2008:

The company enjoys one month’s credit from suppliers of raw materials and maintains

2 months stock of raw materials and one and a half months finished goods. Cash

balance is maintained at Rs 1, 00,000 as a precautionary balance. Assuming a 10%

margin, find out the working capital requirements of ABC Ltd. Cost of sales for

computation of debtors and stock of finished goods may be taken at sales minus gross

profit as per rate of gross profit given.


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Illustration 8:

A proforma cost sheet of a company provides the following particulars:

Elements of Cost:

Material 40%

Direct Labour 20%

Overheads 20%

The following further particulars are available:

(a) It is proposed to maintain a level of activity of 2, 00,000 units.

(b) Selling price is Rs 12/- per unit.

(c) Raw materials are expected to remain in stores for an average period of one month.

(d) Material will be in process, on averages half a month and is assumed to be consisting

of 100% raw material, wages and overheads.

(e) Finished goods are required to be in stock for an average period of one month.

(f) Credit allowed to debtors is two months.

(g) Credit allowed by suppliers is one month.

You may assume that sales and production follow a consistent pattern.

You are required to prepare a statement of working capital requirements, a

forecast Profit and Loss Account and Balance Sheet of the company

assuming that:


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Working Notes:

Profits have been ignored while preparing working capital requirements

for the following reasons:

(i) Profits may or may not be used for working capital.

(ii) Even if profits have to be used for working capital, they have to be reduced by the

amount of income tax, dividends, etc.


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(b) Interest on debentures has been assumed to have been paid.

Related Articles:

1. Forecasting of Working Capital Requirement: 6 Steps

2. Estimating Working Capital Requirements: Top 3 Methods

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Estimating Working Capital Requirement: Top 5 Methods ......Illustration 2: The following are the extracts from the balance sheet of a company as on 30.6.2008. Compute the additional