3 METHODS OF ESTIMATING WORKING CAPITAL :
1. Percentage of Sales Method:
This approach to estimate the working capital requirement is based on the fact that the working capital for any firm is directly related to the sales volume of that firm. So, the working capital requirement is expressed as a percentage of expected sales for a particular period. This approach is based on the assumption that higher the sales level, the greater would be the need for working capital.
This approach to estimate the working capital requirement is based on the fact that the working capital for any firm is directly related to the sales volume of that firm. So, the working capital requirement is expressed as a percentage of expected sales for a particular period. This approach is based on the assumption that higher the sales level, the greater would be the need for working capital.
There are three steps involved in the estimation of working capital.
a) To estimate total current assets as a % of estimated net sales.
b) To estimate current liabilities as a % of estimated net sales, and
c) The difference between the two above, is the net working capital as a % of net sales.
This method is based on the principle of ‘history repeats itself’. For estimating, relationship of sales and working capital is worked out for say last 5 years.
If it is constantly coming near say 40% i.e. working capital level is 40% of sales, the next year estimation is done based on this estimate. If the expected sales is 500 million dollars, 200 million dollars would be required as working capital.
Advantage of this method is that it is very simple to understand and calculate also.
Disadvantages-
1. Its assumption are difficult to be true for many organizations.
1. Its assumption are difficult to be true for many organizations.
2. If there is no linear relationship between the revenue and working capital, this method is not useful.
3. Not applicable in new start-up projects because there is no past.
3. Not applicable in new start-up projects because there is no past.
2. Regression Analysis Method:
This is a statistical estimation tool that establish trend relationship and for working capital estimation.
This method expresses the relationship between revenue & working capital in the form of an equation
Working Capital = Intercept + Slope * Revenue.
Working Capital = Intercept + Slope * Revenue.
Slope is the rate of change of working capital with one unit change in revenue. Intercept is the point where regression line and working capital axis meets .
3. Operating Cycle Method
Time which is needed to convert raw material into finished goods, finished goods into sales and account receivable into cash is called operating cycle.
Under operating cycle method, time needed for different types of current assets and time lag needed for payment of purchase and expenses are considered to compute requirement of working capital.
OPERATING CYCLE =
RAW MATERIAL HOLDING PERIOD
+ WORK IN PROGRESS (WIP) CONVERSION PERIOD
+ FINISHED GOODS CONVERSION PERIOD
+ DEBTORS CONVERSION PERIOD
-- CREDITORS CONVERSION PERIOD (DEFFERED PAYMENT )
The items of current assets and current liabilities are calculated as follows:
* Raw material inventory = (Annual output x material cost per unit x inventory holding period)/Total Periods
* Work-in-progress Inventory = (Annual output x Manufacturing cost per unit x Inventory holding period)/Total periods
* Finished Goods Inventory
= (Annual output x total cost per unit x inventory holding period)/Total periods
* Account Receivable(Debtors)
= ( Annual credit sales units x total cost per unit x credit period allowed)/Total periods
* Prepaid Expenses
= (Annual Expenses x Advance Period)/Total periods
* Account Payable (Creditors)
= (Annual output x raw material cost per unit x credit period)/Total periods
* Outstanding Wages
= (Annual output x labor cost per unit x time lag)/ Total periods
* Outstanding Overhead
= (Annual output x overhead per unit x time lag)/Total periods
* Outstanding Expenses
( Annual expenses x Time lag)/ Total periods
* Work-in-progress Inventory = (Annual output x Manufacturing cost per unit x Inventory holding period)/Total periods
* Finished Goods Inventory
= (Annual output x total cost per unit x inventory holding period)/Total periods
* Account Receivable(Debtors)
= ( Annual credit sales units x total cost per unit x credit period allowed)/Total periods
* Prepaid Expenses
= (Annual Expenses x Advance Period)/Total periods
* Account Payable (Creditors)
= (Annual output x raw material cost per unit x credit period)/Total periods
* Outstanding Wages
= (Annual output x labor cost per unit x time lag)/ Total periods
* Outstanding Overhead
= (Annual output x overhead per unit x time lag)/Total periods
* Outstanding Expenses
( Annual expenses x Time lag)/ Total periods
