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Methods of Estimation of Working Capital Requirement

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© 2019 IJRAR May 2019, Volume 6, Issue 2 www.ijrar.org (E-ISSN 2348-1269, P- ISSN 2349-5138)

Methods of Estimation of Working Capital

Requirement

DR. VIKAS SHROTRIYA

Associate Dean,
Faculty of Management,
Vivekananda Global University,
Sector 36, NRI Road, Jagatpura, Jaipur – 303 012

Abstract

Working capital is required by every organization and it is required more by manufacturing concerns. In

service industry, the amount of working capital required is limited. In manufacturing firm inventory forms a major

component of working capital. Working capital is required in order to have smooth manufacturing and sales

operations, to honour payments and to maintain a smooth operating cycle. In the absence of working capital, it is

not be possible to run any business successfully for long time. Working capital is the money required to carry on

daily operations of a business. Working capital is also known as current assets employed in the business for

shorter duration of time, usually limited up to a maximum of one year. These current assets include cash, cash

equivalents, inventory, receivables, any pre paid amounts etc. these current assets are utilized to create finished

goods and to sell them either for cash or at credit. Certain amount of funds is needed to finance these current

assets, in order to conduct the business. The issue related to these current assets is to find the answer to the

question as to how much amount should be engaged in these assets. If larger amount of cash is held, there are

pretty high chances that there would be idle cash. If cash is not being utilized, it looses its purchasing power. There

are also chances of lose through theft etc. In case of inventory is held at liberal levels then there are chances of

misuse of inventory items, there can be pilferage etc. if receivables mount to larger amounts then the chances of

bad debts increase. The point to make here is that only an optimum amount can be engaged as working capital.

This is also because money also has its cost. Money also has earning power and the earning opportunity is lost

when money lies idle or it is misused. Excess funds invested as working capital also increase the cost of funds.

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Due to all these reasons it is obvious that the amount engaged as working capital should only be as per the

operational requirements of the organization. The methods of estimating working capital are discussed in the

coming paragraphs.

Keywords: Working capital, working capital requirements, methods of estimation.

Introduction

Working capital is required to run any organization. All businesses need day to day cash to carry on daily

operational activities. Working capital is also known as current assets, due to very justified reason that the life of

such assets is one financial year at the maximum. These current assets are used for uninterrupted production and

sales operations in the organization. Working capital has to be optimum in quantity. If the working capital is less

than requirement, there would be issues like disturbance in production, non availability of finished goods for sale,

non availability of cash for honouring payables etc. In case of stringency of cash, there would be loss of bargaining

opportunities. The company would also not be able to take advantage of cash discount. Company would also not

be in position to place large orders of raw material etc. less working capital may also pressurize the organization to

carry on business on cash basis only and the opportunity of credit business may be lost. This would directly affect

the sales of the company and the profit, in turn. Less cash reserves may fail to impress banks and financial

institutions, in the time of applying for overdraft facility or asking for loan etc. On the contrary, if working capital

components are held in abundance, there would be possibility of misuse of material, there would be misuse of cash

even and delays in the collection of receivables etc. there would not be regular operations in both the cases. Thus,

it is advised that the amount engaged in current assets should be optimum. When the current assets are optimum,

the cost of funds is also at the controlled level. Optimum amount of cash would not only help in controlling overall

cost of funds but also check the misuse of liquid resources. Optimum inventories ensure that the cost of purchasing

inventory, the cost of placing orders and the cost of carrying inventory are at the minimum. If finished goods

inventory is available there is no loss of sale. Less work in process inventory would mean fewer blockages of

funds in the transformation process. Less receivable would ensure proper management of receivables and also

ensure efficient collection of receivables. Sufficient working capital also ascertains timely honouring of payables

which is crucial for maintaining organization’s image in the market. Optimum working capital has many other

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advantages as well. The return on investment on the amount locked as working capital remains at moderate level

due to total lower cost on lower amount of funds involved. Every time the company does not have to run for

arrangement of funds for working capital. Thus, it inculcates the feeling of confidence in the employees of the

company. It creates a positive image of the company in the eyes of the employees, creditors, debtors, bankers and

other related parties like distributors etc. the company can also focus on other aspects of business. Thus, it is really

advantageous to have optimum amount of current assets employed in the business.

Methods of estimation of working capital

To arrive at the figure of working capital required to conduct the business smoothly, is not that much

difficult. There are methods for such estimation. The easiest method is to calculate the percentage of working

capital to sales revenue. The company is aware of its fixed cost, variable cost per unit, breakeven point and its

production capacity or targeted sales. The company can easily calculate the total cost to be borne by it and then the

percentage of total cost to total sales revenue.

Percentage of sales method

Let us first consider the percentage of sales method, to estimate the working capital requirement of the

company. This is a simple method which is easily understandable. Let us take a hypothetical example, as follows:

Table1: Percentage of Sales method

For production capacity of 1000 units (100%)

Particulars Rs

Inventories (a) 75000

Receivables (b) 50000

Cash and bank (c) 25000

Gross working capital (d)=(a+b+c) 150000

Payables (e) 50000

Net working capital (f)=(d-e) 100000

Sales revenue (g) 180000

Gross working capital to sales (h) 83%

Net working capital to sales (i) 56%

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As shown in Table 1, gross working capital is 83% of sales while net working capital is 56% of total sales

revenue. Now if the company plans for a sales revenue of Rs 250000, the gross working capital required would be

83% of sales revenue i.e. Rs 207500 and net working capital would be 56% of sales i.e. Rs 140000. This method

of estimating working capital is very effective in short run. It gives an idea of the working capital requirement in

simple terms. It is a simple method as the percentage of sales as working capital is to be calculated. However, this

method gives an approximate value of working capital. This method does not consider any discount received or

provided. This may also apply to other methods of estimation of working capital, as discussed in following

paragraphs.

Regression equation method

Another method to estimate working capital on the basis of sales is the regression method. Regression

analysis can be used to calculate the amount of working capital on the basis of sales of previous years. Let us

consider following hypothetical example:

Table 2: Calculation for Regression Equation

Year Sales (x) Rs Working Capital (y) Rs xy x2

20X1 280 185 51800 78400
20X2 300 245 73500 90000
20X3 410 335 137350 168100
20X4 490 360 176400 240100
20X5 530 410 217300 280900
N=5 ∑x=2010 ∑y=1535 ∑xy=656350 ∑x2=857500

The relationship between sales (x) and working capital (y) is given by the following equation:

y = a + bx

The value of ‘a’ and ‘b’ can be obtained using following equations:

∑y = na + b∑x

∑xy = a∑x + b∑x2

Let us calculate the values of ‘a’ and ‘b’ for the sales and working capital figures provided in Table 2.

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1535 = 5a + 2010b

656350 = 2010a + 857500b

Solving these equations, a = - 10.58 and b = 0.79.

Using the regression equation and values of ‘a’ and ‘b’, the amount of working capital can be calculated for

the sales of Rs 595 for 20X6, as follows:

y = - 10.58 + 0.79 (595) = 459.47

Thus, the working capital estimated is Rs 459.47 for the sales of Rs 595 for the year 20X6. This method is

more accurate in comparison to the percentage to sales method. This technique is based on the figures of sales of

previous years. This method is technical in nature and requires knowledge of regression analysis. Using this

method, it is also possible to calculate the amount of sales on the basis of working capital. This method considers

the data from the previous years and is thus is a better method of estimating working capital.

Operating cycle method

Yet another simple method of estimating working capital is operating cycle method. The amount of

working capital depends upon the operating cycle. Let us consider the following hypothetical example:

Exhibit 1: Estimation of Working Capital using Operating Cycle Method

Estimated cost of goods sold = Rs 800000

Length of operating cycle = 90 Days

Desired cash balance = Rs 150000

Assumed number of days per year = 360

The working capital from the above information can be estimated as follows:

Working capital = [Estimated cost of goods sold X (Operating cycle / 360)] + Desired cash balance

= [800000 X (90 / 360)] + 150000 = Rs 350000

This method can be used when the length of operating cycle is known as this method is based on operating

cycle. This method is simple to understand and not much technical. However, this method utilizes the length of

operating cycle. So in order to use this method it is obvious to know the stages of operating cycle. Once the length

of different stages is known and cost of goods sold is calculated, the amount of working capital can be estimated.

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Individual component approach

Yet another method to estimate working capital is to first estimate different components of current assets

and current liabilities and then sum them up to arrive at the required working capital. This method can prove to be

more effective as it considers all item of working capital. This method involves calculations related to cash,

inventories, debtors, creditors, other payments and expenses etc. along with time duration of each component. Let

us consider the following hypothetical example, to forecast working capital requirement of an organization for a

level of production activity of 130000 units where 30% sales are cash and cash and bank balance is expected to be

Rs 100000:

Table 3: Estimation of Different Components of Current Assets

Particulars

Item Cost per unit Time for holding Amount involved (Rs)
(Rs) (in weeks)
Raw material 100 4 =(130000/52)X4X100=1000000

Labour 50 2 =(130000/52)X2X50=250000

Overheads 80 1 =(130000/52)X1X80=200000

Finished goods 230 3 =(130000/52)X3X230=1725000

Selling price 280

WIP Inventory 2 5000 Units, 825000

Debtors 2 =(130000/52)X2X280=1400000

Creditors 1 =(130000/52)X1X100=250000

Exhibit 2: Estimation of Working Capital using Information in Table 3

Current assets Rs
Desired cash and bank balance 100000
Raw material inventory 1000000
WIP inventory 825000
Finished goods inventory 1725000
Debtors 1400000
------------------------------ --------------
Total current assets (A) 5050000

Current liabilities
Creditors 250000
Labour 250000
Overheads 200000
------------------------------- -------------
Total current liabilities (B) 700000
Net working capital (A) – (B) 4350000

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In this method, first of all, all components are calculated and then gross and net amount of working capital

is estimated. This method is more detailed and seems to be more accurate as all components of working capital are

considered and calculated and then the amount of working capital is reached at. This method involves technical

knowledge as the estimator needs to know the constituents of working capital, items of currents and current

liabilities and the calculation of amount for all such components as per their holding period. In the absence of this

expertise, the amount of working capital cannot be calculated using this method.

Advantages of estimation of working capital

These four methods of estimating working capital are very useful for the organizations as organizations are

always interested in knowing the optimum amount of working capital needed by them. This is ultimately helpful in

reducing the cost of funds involved in current assets. This further helps in increasing the overall profitability of the

organization. Estimation of working capital is also advantageous in case the organization has to arrange for funds.

This activity proves as a proactive measure for arrangement of funds. The organization can approach the bank or

financial institution for short term loan or overdraft facility. The estimation of working capital also helps in

planning for expansion of production facilities. In case, of increment in utilization of capacity the estimation of

working capital is really helpful. At different levels of production the working capital requirements are different

and an estimation of working capital indicates about the funds required to continue the operating cycle at various

levels of production activity. If the working capital is looked from the view point of current ratio then also it is

implied that current assets and current liabilities should be equal. A current ratio of less than one indicates that the

organization has more current liabilities in comparison to current assets, which is not advisable. This would also

imply a quick ratio of less than one as inventories constitute major part of working capital of any firm. This would

also imply that there is zero net working capital. Zero working capital forces the firm to operate within the

boundaries of current assets available and to honour current liabilities on time. Estimation of working capital gives

an idea about the picture of various components of current assets and current liabilities which ultimately helps the

organization to check the opportunity cost of the excess funds which may be employed in working capital beyond

requirement.

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Conclusion

Working capital is needed by all organizations. The amount may vary depending on the type and size of the

organization. Estimation of working capital helps in avoiding the situation over trading and under trading. Over

trading has higher probability of leading to the situation of cash stringency. It is dangerous to work with working

capital amount which is less than required. In the situation of over trading, there is loss of earning capacity of cash

and also there are more chances of misuse of current assets. When any item is available in abundance, it is human

tendency to not to bother about its usage. There is no control exerted on its use. These are the reasons due to which

situation of under trading and over trading should be avoided. Thus, it is advantageous to arrive at the optimum

amount of working capital required by the organization. Working capital can be estimated by using different

methods. Most popular method is percentage to sales method as it is easy to understand and easy to calculate.

However, this method gives an approximate value of the working capital as levels of sales vary with production

activity. Another method for estimation of working capital is regression analysis. This method calculates working

capital on the basis of sales of past years. This method is a little bit technical and the forecaster needs to have the

knowledge of calculation of regression coefficients and regression equations. This method is considered more

accurate as it is based on past data of the organization. Using this method, sales can also be calculated on the basis

of working capital data of previous years. Yet another method of estimation of working capital is operating cycle

method. This method utilizes the length of operating cycle. The organization needs to know the amount engaged in

the operating cycle. This method calculates the amount of required working capital. Working capital can also be

estimated using individual component method. In this method first the amount involved in different components of

current assets and current liabilities are worked out and then all amounts of current assets are summed up and

current liabilities are deducted from the total of current assets to reach to the figure of net working capital. The

amount of working capital calculated using different methods may be different but estimation of working capital is

useful for the organization for efficient working. For perfect use of working capital, there should be

synchronization between production and sales activities. There should be strict discipline in completion of

operating cycle in stipulated time period. If the operating cycle is completed on time, the organization has the

required cash to enter into next operating cycle.

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