ESTIMATING WORKING CAPITAL REQUIREMENTS
To facilitate, estimate the extent of working capital requirement of a firm, various factors are to be considered. There are various methods for estimating the working capital requirements of a firm. They contain -
i) Estimation of components of working capital method,
ii) Percent of sales method and
iii) Operating cycle method
1. Estimation of components of working capital method
As the concept of net working capital relates to the variation between current assets and current liabilities, estimation of both may provide the potential working capital requirement of the firm.
2. Percent of sales method
According to Percent of sales method, based on the past data, the relationship between sales and working capital is found out and expressed as a ratio. The calculation and application of this ratio on estimated future sales will give the extent of working capital requirements of the firm.
3. 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.