Working Capital Management – Procedure | Estimation | Calculation

Working Capital Management refers to the process of managing a company's short-term assets and liabilities to ensure it maintains sufficient cash flow to meet its short-term debt obligations and operational expenses. This management practice is crucial for maintaining a firm's liquidity, operational efficiency, and overall financial health. Key components of working capital management include managing inventories, accounts receivable and payable, and cash. Effective working capital management helps a company to optimize its net current assets and is a critical aspect of financial management that can impact profitability and liquidity.

Table of Contents

1. Estimation Procedure
2. Working Capital as a Percentage of Net Sales
3. Working Capital as a Percentage of Total Assets
4. Working Capital Based on Operating Cycle
5. Estimation of Working Capital Requirement
6. Double Shifting Work

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“The fact that cash inflows are not matched in both timing and amount by cash outflows, provides us with an operating cycle and rationale for investing in working capital. In any analysis of working capital, a distinction is made between temporary and permanent working capital requirements. The latter are a function of secular and cyclical trends in sales and operating expenses. The former depend on seasonal factors. In a proforma projection of working capital requirements, management must forecast the maximum level of current assets required to support an expected volume of sales and maximum level of short term credit it can anticipate to finance these assets.”¹

The efficiency of the planning and management is subject to the correct estimate of the working capital requirement. Irrespective of the planning exercise made and control mechanism adopted, the correct estimation of working capital requirement is the fundamental necessity of a good and efficient working capital management. The present article looks into the steps and calculations required to estimate the working capital requirement for a firm.

1. Estimation Process

A firm must estimate in advance as to how much net working capital will be required for the smooth operations of the business. Only then, it can bifurcate this requirement into permanent working capital and temporary working capital. This bifurcation will help in deciding the financing pattern i.e., how much working capital should be financed from long term sources and how much be financed from short term sources. There are different approaches available to estimate the working capital requirements of a firm.

2. Working Capital as a Percentage of Net Sales

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. The working capital estimation is thus, solely dependent on the sales forecast. 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.

• To estimate total current assets as a % of estimated net sales.
• To estimate current liabilities as a % of estimated net sales, and
• The difference between the two above, is the net working capital as a % of net sales.

So, the firm has to find out on the basis of past experience, or on the basis of other firm’s experience in the same competitive environment, as to how much total current assets and total current liabilities should be maintained for a given level of expected sales. The step (a) above i.e., total current assets as a % of net sales will give the gross working capital requirement and step (b) above i.e., current liabilities as a % of net sales will give the funds provided by current liabilities. The difference between the two is the net working capital which the firm has to arrange for. For example, the following information is available for ABC Ltd. for past three years, on the basis of which the working capital requirement for the next year is to be estimated, given that the sales are expected to increase by 10% over sales level of current year.

In this case, the average of current assets as a % of sales is 21% i.e., (20%+21%+22%)/3; and the average of current liabilities as a % of sales is 5%. So, the net working capital as a % of sales is 16% i.e., 21%-5%. Now, if the firm expects an increase of 10% in sales next year, then its working capital requirement can be estimated as follows:

Expected Sales =    Rs. 14,00,000 + 10% thereof = Rs. 15,40,000.

Net working capital as a % of sales = 16%. = Rs. 15,40,000 × 16% = Rs. 2,46,400.

The firm is expected to have gross working capital of Rs. 3,23,400 (i.e., 21% of Rs. 15,40,000) out of which financing by current liabilities is expected to be Rs. 77,000 (i.e., 5% of Rs. 15,40,000). It may be noted that in the above situation the simple arithmetic average of current assets and current liabilities as a % of sales have been taken. If there is a consistent trend (increase or decrease) in current assets or current liabilities or both, then the weighted average may be preferred.

3. Working Capital as a Percentage of Total Assets or Fixed Assets

This approach of estimation of working capital requirement is based on the fact that the total assets of the firm are consisting of fixed assets and current assets. On the basis of past experience, a relationship between

• total current assets i.e., gross working capital; or net working capital i.e., Current assets – Current liabilities, and
• total fixed assets or total assets of the firm is established. For example, a firm is maintaining 20% of its total assets in the form of current assets and expects to have total assets of Rs. 50,00,000 next year. Thus, the current assets of the firm would be Rs. 10,00,000 (i.e., 20% of Rs. 50,00,000).

In this approach, the working capital may also be estimated as a % of fixed assets. The firm basically plans the future level of fixed assets in terms of capital budgeting decisions. In order to use these fixed assets in an efficient and optimal way, the firm must have sufficient working capital. So, the working capital requirement depend upon the planned level of fixed assets. The estimation of working capital therefore, depends upon the estimation of fixed capital which depends upon the capital budgeting decisions. It has already been noted in Chapter 8 that the investment decisions of a firm are consisting of capital budgeting decisions (relating to fixed assets) and working capital management (relating to current assets and current liabilities). So, the working capital estimation, being a part of the investment decisions, should be made together with the capital budgeting decisions.

Both the above approaches to the estimation of working capital requirement are relatively simple in approach but difficult in calculation. The main shortcoming of these approaches is that these require to establish the relationship of current assets with the net sales or fixed assets, which is quite difficult. The past experience either may not be available, or even if available, may not help much in correct estimation. There is yet another approach to estimate the working capital requirement based on the concept of operating cycle.

4. Working Capital based on Operating Cycle

The concept of operating cycle, as discussed in the preceding chapter, helps determining the time scale over which the current assets are maintained. The operating cycle for different components of working capital gives the time for which an assets is maintained, once it is acquired. However, the concept of operating cycle does not talk of the funds invested in maintaining these current assets. The concept of operating cycle can definitely be used to estimate the working capital requirements for any firm.

In this approach, the working capital estimate depends upon the operating cycle of the firm. A detailed analysis is made for each component of working capital and estimation is made for each of these components. The different components of working capital may be enumerated as follows:

Different components of current assets require funds depending upon the respective operating cycle and the cost involved. The current liabilities, on the other hand, provide financing depending upon the respective operating cycle or the lag period in payment. The estimation of working capital requirement can now be made as follows:

(a) Need for Cash and Bank Balance: Every firm must maintain some minimum cash and bank balance (i.e., immediate liquidity) to meet day to day requirement for petty expenses, general expenses and even for cash purchases. The minimum cash requirement for these transactions can be estimated on the basis of past experience. The need or motives for holding cash and bank balance have been discussed in detail in the next chapter. However, it must be noted, at this stage that the cash and bank balance must be estimated correctly for two reasons:

(i) That the cash and bank balance is the least productive of all the current assets, hence a minimum balance be maintained, and

(ii) The cash and bank balance provide liquidity to the firm, which is of utmost importance to any firm.

The minimum cash and bank balance is also considered while preparing the cash budget for the firm.

(b) Need for Raw Materials: Every manufacturing firm has to maintain some stock of raw material in stores in order to meet the requirements of the production process. The number of units to be kept in stores for different types of raw materials depend upon various factors such as raw material consumption rate, time lag in procuring fresh stock, contingencies and other factors. For example, if it takes 5 days to procure fresh stock of raw materials, and 50 units are used daily, then there should be a minimum of 250 units in stock. The firm may also like to have a safety stock of 20 units. Thus, the total units to be maintained in stores would be 270 units. If the cost per unit of this item of raw material is Rs. 10 per unit, then the working capital requirement is Rs. 2,700 (i.e., 270 × Rs. 10).

(c) Need for Work-in-progress: In any manufacturing firm, the production process is continuous and is generally consisting of several stages. At any particular point of time, there will be different number of units in different stages of production. Some of these units may be 10% complete, some may be 60% complete and some may be even 99% complete. These units, which can neither be defined as raw material nor as finished goods, are known as work-in-progress or semi-finished goods. The value of raw material, wages and other expenses locked up in these semi-finished units is the working capital requirement for work-in-progress.

It may be noted that all the units are not equally completed and hence valuation of all these units is a difficult job. For this purpose, certain assumptions may be made as follows:

(i) The production process starts with the intake of full raw material. So, the value of raw material locked up in work-in-progress will be equal to full cost of number of units of raw material being represented in work-in-progress.

(ii) The units in work-in-progress may be unfinished with respect to labour expenses and overhead expenses only. Some of these units may be 10% complete, some may be 75% complete and some may be even 80% complete and so on. It is assumed for simplification, that all work-in-progress units are on an average 50% complete with respect to labour and overhead expenses. However, if some other information is given, then the valuation of work-in-progress may be made accordingly.

(d) Need for Finished Goods: In most of the cases, be it a trading concern or a manufacturing concern, the goods are not immediately sold after purchase/procurement/completion of production process. The goods in fact, remain in stores for some times before they are sold. The cost which is already incurred in purchasing, procuring or production of these units is locked up and hence working capital is required for them. It may be noted that these finished goods are valued on the basis of cost of these units. The carriage inward ofcourse, is included.

(e) Need for Receivables: The term receivables include the debtors and the bills. When the goods are sold by a firm on cash basis, the sales revenue is realized immediately and no working capital is required for after sale period. However, in case of credit sales, there is a time lag between sales and collection of sales revenue. For example, a firm makes a credit sale of Rs. 1,50,000 per month and a credit of 15 days given to customers. The working capital locked up in receivables is Rs. 75,000 (Rs. 1,50,000 × 1/2 month).

However, an important point is worth noting here. The calculation of Rs. 75,000 is based upon the selling price, whereas the actual funds locked up in receivables are restricted to the cost of goods sold only. There is no investment in profit element as such. Therefore, it is better to calculate the working capital locked up in receivables on the cost basis. Thus, if the firm is selling goods at a gross profit of 20% then the working capital requirement in the above case, for receivables would be Rs. 60,000 only (i.e., Rs. 75,000 × 80%).

The total of working capital requirement for all the above elements is also known as the gross working capital of the firm. At any particular point of time every firm requires this gross working capital as there will be some units of raw materials in stores, some units in work-in-progress, some units as finished goods and there will be some debtors yet to be collected.

(f) Creditors for the Purchases: Likewise a firm sells goods and services on credit it may procure/purchases raw materials and finished goods on credit basis. The payment for these purchases may be postponed for the period of credit allowed by suppliers. So, the suppliers of the firm in fact provide working capital to the firm for the credit period. For example, a firm makes credit purchases of Rs. 60,000 per month and the credit allowed by the suppliers is two month, then the working capital supplied by the creditors is Rs. 1,20,000 (i.e., Rs. 60,000×2 months). It means that the firm would be getting the supplies without however, making the payment for two months. The postponement of the payment to the creditors makes the firm to utilize this money elsewhere or help the firm to sell on credit without blocking its own funds.

(g) Creditors for Expenses and Wages: Usually, the expenses and wages are paid at the end of a month. However, these wages and expenses accumulate in the work-in-progress and finished goods on a regular basis. The time lag in payment of wages and other expenses also provide some working capital to the firm. It may be noted that these wages and expenses are considered for the valuation of work-in-progress and finished goods, but are paid usually at the end of the month, providing a working capital to the firm for that period.

The working capital estimation as per the method of operating cycle, is the most systematic and logical approach. In this case, the working capital estimation is made on the basis of analysis of each and every component of the working capital individually. As already discussed, the working capital, required to sustain the level of planned operations, is determined by calculating all the individual components of current assets and current liabilities. There are different steps required for estimation of working capital based on operating cycle. These steps are:

1. Identify the current assets and current liabilities to be maintained. Estimation of each element of current assets and current liability is required.
2. Determine the average operating cycle (or holding period) for each of these elements. Calculation of different holding periods has been explained in the previous chapter.
3. Find out the rate per unit for each of these elements. For example, the rates of raw materials, work in progress, finished goods are to be ascertained.
4. Find out the amount (funds) expected to be blocked in each of these elements. For example, in raw materials, the funds blocked are: Av. holding period × No. of units required Per Period × Rate per unit.
5. Prepare the working capital estimation sheet and find out the working capital requirement.

The following points are also worth noting while estimating the working capital requirement:

1. Depreciation: An important point worth noting while estimating the working capital requirement is the depreciation on fixed assets. The depreciation on the fixed assets, which are used in the production process or other activities, is not considered in working capital estimation. The depreciation is a non-cash expense and there is no funds locked up in depreciation as such and therefore, it is ignored. Depreciation is neither included in valuation of work-in-progress nor in finished goods. The working capital calculated by ignoring depreciation is known as cash basis working capital. In case, depreciation is included in working capital calculations, such estimate is known as total basis working capital.
2. Safety Margin: Sometimes, a firm may also like to have a safety margin of working capital in order to meet any contingency. The safety margin may be expressed as a % of total current assets or total current liabilities or net working capital. The safety margin, if required, is incorporated in the working capital estimates to find out the net working capital required for the firm. There is no hard and fast rule about the quantum of safety margin and depends upon the nature and characteristics of the firm as well as of its current assets and current liabilities.

6. Double Shifting Work

In case, the firm is operating in double shift then a few adjustments are required in the working capital estimation. The double shift working has an effect on the working capital requirement. The reason being that extra working (production) would require additional raw materials and would result in higher stock of finished goods. Sometimes, the firm may be required to pay a higher wage rate to the labour. Fixed costs of production may remain same or may increase. The calculation of working capital requirement for double shift should be made depending on the information. If sufficient information is not available, then some assumptions may be made as follows:

1. That the requirement of raw material will increase proportionately. The storage period of raw material may remain same. Similarly, stock of finished goods will also increase.
2. The work on work-in-progress of the first shift will continue in the second shift and no extra funds would be blocked in the work in progress.
3. Fixed costs may remain same, and consequently, the fixed cost per unit will decrease as the total production increases.
4. The cost of raw materials and the selling price per unit of finished goods may decrease because of larger volumes. This change should be incorporated in the working capital estimation.

The effects of different CA and CL on working capital requirement due to Double Shift Operations are given below:

1. Curran, W.S., Principles of Financial Management. McGraw-Hill Book Company, New York, First Edition, p. 161.