Computation of Working Capital - Accountancy and Financial Management | Accountancy and Financial Management - B Com PDF Download

Computation (Or Estimation) Of Working Capital

Working Capital requirement depends upon number of factors, which are already discussed in the previous parts. Now the discussion is on how to calculate the Working Capital needs of the business concern. It may also depend upon various factors but some of the common methods are used to estimate the Working Capital.

A. Estimation of components of working capital method Working capital consists of various current assets and current liabilities. Hence, we have to estimate how much current assets as inventories required and how much cash required to meet the short term obligations. Finance Manager first estimates the assets and required Working Capital for a particular period.

B. Percent of sales method Based on the past experience between Sales and Working Capital requirements, a ratio can be determined for estimating the Working Capital requirement in future. It is the simple and tradition method to estimate the Working Capital requirements. Under this method, first we have to find out the sales to Working Capital ratio and based on that we have to estimate Working Capital requirements. This method also expresses the relationship between the Sales and Working Capital.

C. Operating cycle Working Capital requirements depend upon the operating cycle of the business. The operating cycle begins with the acquisition of raw material and ends with the collection of receivables.

Operating cycle consists of the following important stages:

1. Raw Material and Storage Stage, (R)
2. Work in Process Stage,(W)
3. Finished Goods Stage, (F)
4. Debtors Collection Stage, (D)
5. Creditors Payment Period Stage. (C)

           Working Capital Cycle  

Each component of the operating cycle can be calculated by the following formula:

Exercise 1

From the following information extracted from the books of a manufacturing company, compute the operating cycle in days and the amount of working capital required:

Solution

Computation of Operating Cycle

(i) Raw material held in stock:

Less: Average credit period granted by Suppliers 16 days/11 days

(ii) Work-in-progress:

(iii) Finished good held in stock:

(iv) Credit period allowed to debtors:

Total operating cycle period: (i) + (ii) + (iii) + (iv) = 44 days

Number of Operating cycles in a year =365/44 = 8.30

= 10,500/8.3

= Rs. 1,265

Alternatively, the amount of working capital could have also been calculated by estimating the components of working capital method, as shown below:

Working Capital Management Policy

Working Capital Management formulates policies to manage and handle efficiently; for that purpose, the management established three policies based on the relationship between Sales and Working Capital.

1. Conservative Working Capital Policy.
2. Moderate Working Capital Policy.
3. Aggressive Working Capital Policy.

1. Conservative working capital policy: Conservative Working Capital Policy refers to minimize risk by maintaining a higher level of Working Capital. This type of Working Capital Policy is suitable to meet the seasonal fluctuation of the manufacturing operation.

2. Moderate working capital policy: Moderate Working Capital Policy refers to the moderate level of Working Capital maintainance according to moderate level of sales. It means one percent of change in Working Capital, that is Working Capital is equal to sales.

3. Aggressive working capital policy: Aggressive Working Capital Policy is one of the high risky and profitability policies which maintains low level of Aggressive Working Capital against the high level of sales, in the business concern during a particular period.

                   Working Capital Policies

Sources Of Working Capital

Working Capital requirement can be normalized from short-term and long-term sources. Each source will have both merits and limitations up to certain extract. Uses of Working Capital may be differing from stage to stage.

                               Sources of Working Capital

The above sources are also classified into internal sources and external sources of working capital.

Internal sources such as:

• Retained Earnings
• Reserve and Surplus
• Depreciation Funds etc

External sources such as:

• Debentures and Public Deposits
• Loans from Banks and Financial Institutions
• Advances and Credit
• Financial arrangements like Factoring, etc

Determining the Finance Mix

Determining the finance mix is an important part of working capital management. Under this decision, the relationship among risk, return and liquidity are measured and also which type of financing is suitable to meet the Working Capital requirements of the business concern. There are three basic approaches for determining an appropriate Working Capital finance mix.

1. Hedging or matching approach
2. Conservative approach
3. Aggressive approach.

Hedging Approach

Hedging approach is also known as matching approach. Under this approach, the business concern can adopt a financial plan which matches the expected life of assets with the expected life of the sources of funds raised to finance assets. When the business follows matching approach, long-term finance shall be used to fixed assets and permanent current assets and short-term financing to finance temporary or variable assets.

          Financing under Matching Approach

Conservative Approach

Under this approach, the entire estimated finance in current assets should be financed from long-term sources and the short-term sources should be used only for emergency requirements. This approach is called as “Low Profit – Low Risk” concept

                       Conservative Approach

Aggressive Approach

Under this approach, the entire estimated requirement of current assets should be financed from short-term sources and even a part of fixed assets financing be financed from short- term sources. This approach makes the finance mix more risky, less costly and more profitable.

                       Aggressive Approach