Estimation of working capital requirements

Recently updated on April 13th, 2023 at 06:31 pm

In estimating working capital needs, different people adopt different approaches. Some experts suggest that the working capital should be greater than the minimum requirements of the firm. The management should feel safety. It would be able to meet its obligations even in adverse circumstances. However, the excessive capital may lead to waste and inefficiency. On the other hand, some experts suggest that the working capital should be lower than the requirement so that no idle funds shall be invested in the current assets and it ultimately leads to increase in profitability of the company. However, in such case the firm always have risk of technical insolvency as it may not meet its obligations as and when they falls due for payment.

There are various approaches which have been applied in practice for the estimation of working capital requirements of a firm. Let’s discuss some of them in brief.

  1. Conservative Approach

The conservative approach states that the proportion of current assets to current liabilities should be kept at 2:1. Is this proportion is to be kept the firm would be able to meet its obligations on time and hence its financial solvency would not be in trouble.  However, the limitation of this approach is that it suggests only quantitative measure. It does not suggest as to what type of assets are to be included in current assets. If the current assets contain stock, which is outdated or receivable which are not collectable, than the amount of current assets has no meaning. Further, in the present scenario no firm maintains this ratio, as it’s too difficult for them to maintain such a high level of current assets.

  1. Components Approach

Here we take up one of the planning models of working capital to estimate working capital. The method adopted here attempts at estimation of working capital and its components by taking into account, the period for which the various items remain as stock or as outstanding, the cost structure of production and annual production. It assumes even production and even sales, throughout and what is produced is completely sold.

  1. Operating Cycle Approach

It was earlier referred to that working capital is also known as revolving capital. That is, a circular path of conversion/re-conversion takes place. Consider this example. You start your business operation with an initial investment. With credit extended by expense creditors (labor, employees, utilities, etc.) you start production process. Goods of varying levels of finish result. This is what we call as work-in-process or work-in-progress. Once complete processing is done, you get finished goods. Until these goods are sold, they remain in stock. Sales may be for cash and/or on credit basis. You need to wait a little to realize cash from the credit customers. The realized cash is used to pay creditors. You need to maintain a cash balance for day-to-day transactions as well as for meeting sudden spurt in payment obligations accompanied by sluggish cash collections from debtors. Thus a revolution or cycle from cash to raw materials to Work in Progress (WIP), to finished goods, to debtors, and back to cash is taking place. This revolution or cycle is known as operating cycle.

Efficient working capital management is one which ensures continuous flow without any interruptions/holdups at any of the stages referred to above and involves as for as possible a rapid completion of the revolutions. In other words, when raw materials remain in store pending issue for production for a less duration, when raw materials get converted into WIP in short duration, when WIP is converted into finished goods in short duration, when finished goods remain in dept pending sales for a short while only, and when cash realizations out of sales are made quickly and finally when payment to creditors is made slowly, the operating cycle would be smaller and consequently the working capital will also be reasonable.

There should be neither too little nor too much investment in working capital. Efficient handling of the operating cycle would make possible the above. Note, what is suggested is optimization, and not minimization of current assets and maximization of current liabilities. That will affect your liquidity and your profitability. Too little means more illiquid, but more profitability, but not more absolute profits. We want both high profitability and high profits. Too much current liability means illiquid but more profitability as it is assumed short-term funds are less expensive for they can be redeemed the moment you don’t need thus saving interest. The reverse is true with too little current liability. Actually the business has to trade-off between risk and return. If it wants less risk it has to carry more current assets and less current liability. This will lead to lower profits. Low risk means low profits. If the business takes more risk, ie., it carries less working capital, it might make more profits. There is no guarantee however that higher level of risk yields higher profits.

In terms of operating cycle concept, too long an operating cycle gives more liquidity but only low returns and vice versa. The optimum operating cycle has to be worked out taking into account the costs and benefits and levels of risk and levels of return for varying lengths of operating cycle.

the important factors determining the requirements of working capital are as follows:

1. Sales:

Among the various factors, size of the sales is one of the important factors in determining the amount of working capital. In order to increase sales volume, the enterprise needs to maintain its current assets. In the course of period, the enterprise becomes in the position to keep a steady ratio of its current assets to annual sales. As a result, the turnover ratio, i.e., current assets to turnover increases reducing the length of operating cycle. Thus, less the operating cycle period, less will be requirements for working capital and vice versa.

2. Length of Operating Cycle:

Conversion of cash through various stages viz., raw material, semi-processed goods, finished goods, sales, debtors and bills receivables into cash takes a certain period of time that is known as ‘length of operating cycle’. Longer the operating cycle time, the more is the working capital required.

For example, heavy engineering needs relatively more working capital than a rice mill or cotton spinning mill or a steel rolling mill. Thus, it follows that depending upon the length of working cycle, the requirement for working capital varies from enterprise to enterprise.

3. Nature of Business

The requirement of working capital also varies among the enterprises depending upon the nature of the business. For instance, trading companies require more working capital than manufacturing companies. This is because that the trading business requires large quantities of goods to be held in stock and also carry large amounts of working capital than manufacturing concerns.

In both these types of businesses, the value of current assets is 80% to 90% of the value of total assets. The investment in current assets is relatively smaller in the case of hotels and restaurants because they mostly have cash sales, and only small amounts of debtors’ balances.

4. Terms of Credit

Another important factor that determines the amount of working capital requirements relates to the terms of credit allowed to the customers. For instance, an enterprise may allow only 15 days credit, while another may allow 90 days credit to its customers. Besides, an enterprise may extend credit facilities to its all customers, while another enterprise in the same business may extend credit only to select and those too reliable customers only.

Then, the requirements for working capital will naturally be more if the credit period is longer and credit facilities are extended to all customers, no matter reliable or non-reliable they are. This is because there will be longer balance of debtors and that too for a relatively longer period which will obviously demand for more capital.

On the contrary, if supplies of raw materials are available on favourable conditions or terms of credit i.e., the payment will be made after a relatively longer period of time, the requirement for working capital will be correspondingly smaller.

5. Seasonal Variations

The seasonal enterprises, i.e., the enterprise whose operations pick up seasonally may require more working capital to meet their increased operations during the particular season. A popular example of seasonal enterprise may be sugar factory whose operations are highly seasonal.

6. Turnover of Inventories

If inventories are large in size but turnover is slow, the small-scale enterprise will need more working capital. On the contrary, if inventories are small but their turnover is quick, the enterprise will need a small amount of working capital.

7. Nature of Production Technology

In case of labour intensive technology, the unit will need more amount to pay the wages and, therefore, will require more working capital. On the other hand, if the production technology is capital- intensive, the enterprise will have to make less payment for expenses like wages. As a result, enterprise will require less working capital.

8. Contingencies

If the demand for and price of the products of small- scale enterprises are subject to wide variations or fluctuations, the contingency provisions will have to be made for meeting the fluctuations. This will obviously increase the requirements for working capital of the small enterprises. While one can add certain other factors to this list, the said factors appear to be the major ones in determining the requirement of working capital of a small-scale enterprise.

Assessment of Working Capital:

The requirement for working capital of a small-scale enterprise needs to be assessed correctly as far as possible. Because, as we mentioned earlier both under and over working capitals are harmful for the enterprise. For example, over-estimation of working capital would result in blockage of scarce funds in idle assets.

On the other hand, under-assessment of working capital would deprive the enterprise of profitable opportunities. It is here that the concept of operating cycle of working capital reveals its sharpness. Let us explain it with an example.

Suppose the operating cycle of a small-scale enterprise is of four months. It means that the cycle of operations is repeated three times in a year. This further means that the enterprise would need an amount of working capital equal to one-third of the operating expenses of the whole last year.

This is best expressed by the following formula:

Total Working Capital Requirement = Total Operating Expenses in the Last Year/Number of Operating Cycles in the Year

In addition, if the prices go up in the coming year, a certain percentage for such contingencies will also be added to above working capital calculated so.

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.

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.

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.

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.

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.

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.

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