The following points highlight the top three methods of working capital estimation. The methods are: 1. Percentage of Sales Method 2. Regression Analysis Method 3. Operating Cycle Method.
1. Percentage of Sales Method:
It is a traditional and simple method of determining the level of working capital and its components. In this method, working capital is determined on the basis of past experience. If, over the years, the relationship between sales and working capital is found to be stable, then this relationship may be taken as a base for determining the working capital for future.
This method is simple, easy to understand and useful for projecting relatively short-term changes in working capital. However, this method cannot be recommended for universal application because the assumption of linear relationship between sales and working capital may not hold good in all cases.
XYZ Ltd. has achieved a turnover of Rs. 85 crores for the accounting year 2007-08. It is anticipated that the turnover of the company will reach Rs. 110 crores for the year 2008-09.
The financial position of the company as on 31st March, 2009 as follows:
Estimate the working capital requirement for the year 2008-09.
Estimation of working capital requirement for 2008-09.
2. Regression Analysis Method:
It is a useful statistical technique applied for forecasting working capital requirements. It helps in making working capital requirement projections after establishing the average relationship between sales and working capital and its various components in the past years. The method of least squares is used in this regard.
The relationship between sales and working capital is given by the equation:
Y = a + bx
x = Sales (independent variable)
y = Working capital level (dependent variable)
a = Intercept of the least square line with vertical axis
b = Slope of the line
Linear regression model is used to judge the relationship of two variables. By using the mode we can estimate level of working capital needed for given amount of sales. The data relating to level of working capital and its corresponding sales during past 5 – 6 years is used in establishment of trend relationship.
The value of ‘a’ and ‘b’ are obtained by the solution of simultaneous linear equations given below:
∑y = na + b∑
∑xy = a∑x + b∑x2
3. Operating Cycle Method:
The operating cycle concept can be used in estimation of working capital. The longer the length of operating cycle, the higher the requirement for working capital and vice versa.
For estimation of working capital, the following formula can be used:
XYZ Ltd. expects its cost of goods sold for 2009-10 to be Rs. 136 crores. The operating cycle for the planned year is expected to be 54 days. The company wants to maintain a desired cash balance of Rs. 1.5 crores to meet the contingencies. What is the expected working capital requirement for the year 2009-10. (Assume 360 days in a year).
Estimation of working capital for the year 2009-10 based on operating cycle.
For proper management of working capital it is required that a proper assessment of its requirement is made. Working capital should be such that it is commensurate with the production needs of the company. For computation of working capital under this method, the estimation of sales or the activity level is need to determine the levels of individual components of working capital.
Expected increase or decrease in sales over the existing level is to be considered for estimation of sales for the next period. Once the assessment is made, every element of working capital has to be monitored.
Under this method each individual items of current assets and current liabilities are estimated as follows:
Raw Material Stock:
It is to be ensured that there is no excess holding of raw material inventory over the required level of quantity. The proper level of stock holding is determined taking into consideration the rate of production, safety stock level, economic order quantity, stock holding costs, lead time for material supplies, amount of working capital required for maintaining stock of raw materials, availability of material etc.
The level of investment in raw material stock is determined taking into consideration the average period for which it is held in stock, e.g., raw materials are held in stock, on an average, for 2 months.
In process industries there is likely to be partly completed units lying in stocks, which require working capital. The production cycle should be reduced to the most optimum level to reduce the level of investment in work-in-progress. In partly completed items, some portion of raw material, labour and overhead costs are incurred, the balance is to be incurred for conversion of it into finished item.
If the information is not available, it is assumed that 100% of material cost is incurred on the item of WIP, but labour and overhead costs are assumed to be incurred to the extent of 50%, e.g., every unit of production remains in the process for 1 month, work-in-process involves use of full unit of raw materials in the beginning of manufacturing process and other conversion costs equivalent to 60%.
Finished Goods Stock:
At the end of production process, the units are converted into finished products, which are held in stock for some time until it is despatched to the customers on sale. The reduction in time lag between completion of production and its sale to ultimate customer should be minimum and production planning should be done to achieve the goal.
To meet the seasonal demand, it might be necessary to hold more stocks of finished goods. The investment in stock of finished goods is determined at cost of goods sold, e.g., finished goods remain in warehouse, on an average, for 2 months.
Investment in Debtors:
The cash sales does not require working capital. But the credit sales will tied- up the funds for some time, until the debtors balance is realized. A proper credit policy has to be established based on creditworthiness of customer. An effective administration of debtors has to be established and properly monitored.
The economics of cash sales, credit sales, cash discounts, trade discounts, factoring etc. should be considered. The actual funds locked-up in debtors balances is only to the extent of cost of goods sold. It would be more practical, if investment in debtors balances is ascertained at cost of sales, not at selling price, e.g., credit allowed to debtors is 2 months from the date of despatch, 20% of sales are on cash basis.
The required cash balance can be determined with the help of preparation of cash budget. Proper cash budget should be prepared and continuous monitoring of the same is required. It should be kept in view that cash balances are the most liquid assets and temporary cash surplus should be properly invested in short-term marketable investments to maximize the return on capital employed.
For meeting the day to day expenses it is necessary to maintain certain amount of cash balances for smooth flow of operations, e.g., the estimated balance of cash to be held Rs. 2,00,000.
Sometimes, the expenses are to be paid in advance, which require the working capital, e.g., sales promotion expenses paid quarterly in advance.
Generally the suppliers of raw materials, consumables, stores etc. will allow credit period for payment called as ‘trade credit’. Creditors provide the company with working capital requirement. The company should negotiate with the suppliers maximum credit period at lowest overall cost.
Credit period should be negotiated for purchases in such a manner that the timings of cash availability is taken into account. The trade credit reduces the level of working capital requirement, e.g., suppliers of materials extend a month credit, cash purchases are 25%.
Creditors for Wages and Expenses:
The wages and expenses may not be required to pay immediately, which will also ease the working capital requirement e.g., there is a time lag in payment of wages of a month and half-a-month in case of overheads.
Any advances received along with purchase orders for the products, reduces the requirement for working capital.
Steps in Determination of Working Capital:
The individual components method of estimation of working capital involves the following steps:
Identify the various items of current assets and current liabilities which consist in determination of working capital. The current assets include inventory of raw materials, WIP and finished goods, sundry debtors, prepaid expenses, desired cash balance etc. The current liabilities include creditors for raw materials, stores and consumables, creditors for wages, creditors for expenses, etc.
(a) Estimate the holding period of each item stock i.e., raw materials, work-in- progress and finished goods.
(b) Estimate the collection period of sundry debtors.
(c) Estimate the desired cash balance for meeting the requirements of day to day operations.
(d) Estimate the payment deferral period of creditors for raw materials.
(e) Estimate the lag in payment of wages and expenses.
(i) Determine the raw material, labour and overheads cost per unit.
(ii) Determine the operating level.
(iii) Determine the percentage of conversion cost incurred on WIP.
(iv) Determine the cost of sale and selling price per unit.
Ascertain the value of each item of current assets and current liabilities taking into account the information in step (2) and step (3).
Put the values of current assets and current liabilities in a statement form and ascertain the net working capital (Le. current assets – current liabilities) after adding up the desired cash balance and amount needed for meeting contingencies.
The Board of Directors of Ruby Ltd. requests you to prepare a statement showing the working capital requirements forecast for a level of activity of 1,56,000 units of production. The following information is available for your calculation:
(a) Raw materials are in stock on average one month.
(b) Materials are in process, on average 2 weeks.
(c) Finished goods are in stock, on average one month.
(d) Credit allowed by suppliers – one month.
(e) Time lag in payment from debtors – 2 months.
(f) Lag in payment of wages – 1 Vi weeks.
(g) Lag in payment of overheads – one month.
20% of the output is sold against cash. Cash in hand and at bank is expected to be Rs. 60,000. It is to be assumed that production is carried on evenly throughout the year. Wages and overheads accrue similarly and a time period of 4 weeks is equivalent to a month.
Approaches to Working Capital Estimation:
In estimation of working capital two approaches are in practice:
(a) Total approach, and
(b) Cash cost approach.
(a) Total Approach:
In this method of estimation all costs including depreciation and profit margin are included. Unless it is asked specifically, the estimation of working capital under total approach is suggested.
(b) Cash Cost Approach:
Under this approach, working capital is estimated on the basis of cash costs. Depreciation is excluded from the cost of sales. The profit margin is also not considered while estimation of investment in debtors balances.
The estimation of different items of working capital is done under total approach and cash cost approach are as follows: