Methods of Estimating Working Capital Requirement [Financial Management Notes for NEP and CBCS Pattern]

Methods of Estimating Working Capital Requirement
[Financial Management Notes for NEP and CBCS Pattern]

Methods of Estimating Working Capital Requirement

There are broadly three methods of estimating the requirement of working capital of a company viz. percentage of revenue or sales, regression analysis, and operating cycle method. Estimating working capital means calculating future working capital. It should be as accurate as possible because planning of working capital would be based on these estimates and bank and other financial institutes finances the working capital needs based on such estimates only.

a) Percentage of Sales Method: 

It is the easiest of the methods for calculating the working capital requirement of a company. 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 are 500 million dollars, 200 million dollars would be required as working capital.

Advantage of this method is that it is simple to understand and calculate also. 

Disadvantage includes its assumption which is difficult to be true for many organizations. So, where there is no linear relationship between the revenue and working capital, this method is not useful. In new startup projects also this method is not applicable because there is no past.

b) Regression Analysis Method: 

This statistical estimation tool is utilized by mass for various types of estimation. It tries to establish trend relationship. We will use it for working capital estimation. This method expresses the relationship between revenue & working capital in the form of an equation (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.

c) Operating cycle method: 

Operating cycle is the time duration required to convert sales, after the conversion of resources into inventories and cash.  The operating  cycle of a manufacturing co involves 3 segments:

i)  Acquisition of resources like  raw labor, material, fuel and power 

ii) Manufacture of the product that includes conversion of raw material into  work  in  process  and into finished goods, and

iii) Sales of the product either for cash or credit.  Credit sales create book debts for collection (debtors).

The length  of  the  operating  cycle  of a  manufacturing co  is  the  sum  of - i)   inventory conversion period (ICP) and ii)   Book debts conversion period (BDCP) collectively, they are sometimes called as gross operating cycle (GOC).

GOC = ICP + DCP

The Inventory conversion period is the entire time needed for producing and selling the product and includes:

(a) Raw material conversion time (RMCP)

(b) Work in process conversion period (WIPCP) and

(C)  Finished good conversion period (FGCP).

ICP = RMCP + WIPCP + FGCP

The payables deferral period (PDP) is the length of time the firm is capable to defer payments on various resource purchases. The variation between the gross operating cycle and payables deferrals period is the net operating cycle (NOC).

NOC = GOC- Payables deferral period.