Computation of Working Capital Requirements

Computation of Working Capital Requirements.A company must be able to assess its working capital requirement appropriately for the hassle-free conduct of business. Bifurcation of the working capital into ‘Permanent Working Capital’ and ‘Temporary Working Capital’ would follow after that, which enables the business entity to take a decision regarding the level of working capital to be financed from long-term sources and the level of working capital to be funded from short-term sources. There are a number of approaches to assess the level of working capital requirement, which are discussed in the following points:

1) Working Capital as a Percentage of Net Sales:

The underlying principle of this approach is that there is a direct relationship between the working capital of a company and the volume of its sales. It is presumed that a higher level of sales warrants a higher level of working capital. The working capital requirement is indicated as a percentage of projected sales for a specific period. In assessing the working capital requirement under this approach, three distinct steps are involved:

  • Assessment of total current assets percentage of projected net sales.
  • Assessment of total current liabilities percentage of projected net sales.
  • The difference between (i) and (ii) would be the net working capital as a percentage of net sales.

This approach is especially useful in calculating the short-term working capital requirements. This approach has been criticized on the ground that it presumes a linear relationship between working capital requirements and projected sales.

2) Working Capital as a Percentage of Total Assets or Fixed Assets :

The assessment of working capital under this approach is based on the fact that sum of the ‘Fixed Assets’ and ‘Current Assets’ of a company constitute Its ‘Total Assets’.

On the basis of historical data, the relationship between ‘Gross Working Capital’ (total current assets), ‘Net Working Capital (current assets minus current liabilities), and ‘Total Fixed Assets’ (total assets minus current assets) of the company is established.

For example, if a company has been historically maintaining 25% of its total assets as current assets and its total assets are projected at 1,00,00,000 next year, its current assets would be 25,00,000.

Working Capital, under this approach, may also be computed as a percentage of fixed assets. The projected level of fixed assets may be planned according to the decisions arrived at during the use 01 ‘Capital Budgeting’ technique. The optimal utilization of fixed assets is possible only if an appropriate level of working capital is maintained by the company.

In brief, the company’s requirement for working capital is dependent on the fixed assets projected by it.

3) Projected Balance Sheet Method:

In this method a ‘Projected Balance Sheet’ is prepared, which in ‘olves future assessment (forecasting) of various components of assets (including cash) as well as that of liabilities ten the basis of past data. The difference between the assets and liabilities of the projected ‘Balance Sheet’ is considered as ‘Surplus’ or ‘Shortage’ of‘ that period. Total liabilities in excess of total assets are indicative of surplus cash, whereas the total assets in excess of total liabilities are indicative of deficient working capital.
In the former scenario, suitable arrangements need to be made for the investment of surpluses, whereas in the latter scenario, the gap of working capital needs to be filled through bank borrowing or some other sources.

4) Adjusted Profit and Loss Method:

On the basis of the past transactions, the estimation of profit is computed. This is adjusted by ‘Cash Inflows’ and ‘Cash Outflows’ to arrive at the figure of increase or decrease in ‘Working Capital’. This method is almost like a ‘Cashflow’ statement and is used by some of Indian banks for the calculation of ‘Working Capital’.

5) Wörking Capital Based on Operating Cycle:

This method may be used by any company for the computation of its ‘Working Capital’. It facilitates estimation of the ‘Time Scale’ for which current assets are held under each stage of the cycle, viz. Raw Material (RM), Work-in-Process (WIP), Finished Goods (FG), Sales, and Sales Proceeds. However, the funds invested in the maintenance of these current assets are not a part of this concept.

Computation of Working Capital Requirements

Under this method, the working capital requirement of a company for a given period may be calculated in relation to the total period of the ‘Net Operating Cycle’ and the cash required for the operating expenses incurred during that period. For this, each component of working capital, via. RM, WIP, FG, Sales, and Sales Proceeds are subject to detailed analysis, and the fund requirement for each component, i.e., current assets, is estimated.

As far as the ‘Current Liabilities’ are concerned, they are the source of finance, the level of which depends upon the respective operating cycles or the gap in receipt of payment. The total operating cycle is equal to the number of days involved in each stage of the cycle, rim. RM, WIP, FG, etc.

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