ABM 801/ L-11: Prof.

Swami Prasad Saxena

Lesson 11
Techniques of Estimating Working Capital Needs
Objectives of the lesson
After studying this lesson, students will be able to:
• Develop understanding of the intricacies of the management of working capital,
• Learn the application of various techniques of estimating working capital.
1.0 Introduction
The level of current assets is determined by the level of operations and the requirement of
working capital is a function of the current assets and current liabilities. The current assets
except cash represent application of funds and the current liabilities are the sources of funds.
The non-synchronous nature of cash inflows and outflows requires a concern to maintain an
excess of current asset to facilitate uninterrupted production. This is done by managing
various components of current assets as against the level of current liabilities. Hence, it
becomes imperative to for the management to manage the levels of current assets for
maximizing the profitability of the firm and increasing the shareholder value.
2.0 Management of Working Capital
Management of working capital follow three approaches:
• Aggressive policy,
• Moderate policy, and
• Conservative policy.
Aggressive working capital policy is highly risky, but profitable as it maintains lo w level of
working capital against the high level of sales; the moderate working capital policy refers to
the system in which firm maintains moderate level of working capital with moderate level of
sales; while conservative working capital policy is least risky because in this system firm
maintains a higher level of working capital. conservative policy is considered better for those
concerns which face seasonal variations in sales. The management of working capital
consists of two main components concerned with (i) Liquidity & Profitability, and (ii)
Investment & Financing.
Liquidity of funds is of prime importance for smooth functioning of business operations. But,
while maintain liquidity, it is important to keep cost aspect in mind because each rupee of
capital bears some cost. Unnecessary tying up of funds in idle assets not only reduces the
liquidity but also lessens opportunity to earn better return from investment in productive
assets. Hence a trade-off between liquidity and profitability is highly needed. It increases
profitability without disturbing routine functioning.

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Adequate Liquidity
Liquidity &
High Productivity
Profitability

Achieving Objectives
Management of
Working Capital
Level of Investment

Investment
Economy in Financing
& Financing
Efficiency in Utilization

The arrangement of funds and their investment in working capital must be done with proper
consideration to economy in financing, efficiency in utilization of funds, and efficiency in
achieving objectives of firm. All this requires proper care in deciding the level of investment
in major current assets such as inventories, accounts receivables, and cash; and identifying
and exploring most economical sources of working capital financing.
3.0 Estimation of Working Capital Needs
Some important methods of estimating working capital needs are: (i) Operating cycle
method, (ii) Estimation of current assets and current liabilities method, and (iii) Cash
forecasting method.
3.1 Operating Cycle/ Working Capital Cycle Method
Business is about investing capital, acquiring the resources, adding value and realizing
investments along with profits. There is an identifiable time lag between the purchase of raw
materials and realization of Sales. The non-synchronous nature of cash outflows and inflows
requires the firms to keep cash or invest in short term liquid securities to allow them to meet
obligations when due. The firm is also required to maintain an inventory of raw materials
and finished goods to prevent the loss of productio n or loss of business opportunity. The
operating cycle of a company can be said to cover distinct stages, each stage requiring a level
of supporting investment.
For a manufacturing firm, the cycle starts with the investment made in raw materials and
other components. The inventories can be bought on trade credit as a result creditors will
increase. Further goods are manufactured that are sold on credit as a result debtors will
increase. Finally, debtors pay in the form of cash or cheque and consequently cr editors are
paid out. The time gap between the firm’s paying cash for materials, entering into work in
process, making finished goods, selling finished goods to the debtors and the inflow of cash

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from debtors is known as working capital or operating cycle. It begins with the acquisition
of raw material and ends with the collection of receivables. It is measured as:
Operating Cycle (O)=R+W+F+D−C
In this equation, components of operating cycle such as raw material holding period, work-
in-progress holding period, finished goods holding period, debtors’ collection period, and
creditors payment period is calculated in terms of number of days for which working
capital is blocked in concerned asset component or working capital advantage is available
to the firm. Here:
Average Stock of Raw Material
Raw Material Holding Period (R) =
Av. Raw Material Consumption Per Day
Average Stock of WIP
WIP Holding Period (W) =
Average Cost of Production Per Day
Average Stock of Finished Goods
Finished Goods Holding Period (F) =
Average Cost of Sales Per Day
Average Book Debts
Debtors Collection Period (D) =
Average Credit Sales Per Day
Average Creditors
Creditors Payment Period (C) =
Average Credit Purchases Per Day
The estimation of working capital needs by operating cycle method involves three steps.
• Measurement of Operating Cycle
Operating Cycle (O) = R + W + F + D − C
• Calculation of Number of Operating Cycles
Days in a Year
Number of Operating Cycles =
Operating Cycles
Number of days in a year may be taken as 365 or 360.
• Measurement of Working Capital
Total Operating Cost
Working Capital =
Number of Operating Cycles
Here, total operating cost means Annual Cost of Sales.
Determination of operating cycle helps in forecasting, controlling, and managing working
capital. The length of operating cycle is an indicator of the efficiency of management. Though,
length of operating cycle depends on nature of business, but, if small (less number of days),

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is considered better. Similarly, the number of operating cycles, if more, is be tter for the
business firm.
3.2 Estimation of Current Assets & Current Liabilities Method
Working capital consists of various current assets and current liabilities. Hence, finance
manager estimates the amount of working capital to be invested in current a ssets such as
inventories, receivables, cash etc. and also the amount of credit it will have from creditors
for goods and services.
This method considers investment of working capital in various components of current
assets and credit advantage from current liabilities.
Here: Working Capital = Current Assets − Current Liabilities
Investment in the components of current assets and credit advantage from current liabilities
is calculated as:
Budgeted Prod.× Cost of RM pu × RM Holding Period
Raw Mat. =
Months or Weeks or Days in a Year
Budgeted Prod.× Avg. Cost of WIP × WIP Holding Pd.
WIP =
Months or Weeks or Days in a Year
Budgeted Prod.× Average Cost of Prod.× FG Holding Period
Finished Goods =
Months or Weeks or Days in a Year
Budgeted Credit Sale × Avg. Cost of Sales × Average Collection Period
Debtors =
Months or Weeks or Days in a Year
Cash and Cash Equivalents: Minimum Cash and Bank Balance desired
Budgeted Credit Purchase × Cost of RM pu × Average Payment Period
Creditors =
Months or Weeks or Days in a Year
Budgeted Lab. Hours × Wage per Hour × Lag in Wage Payment
O/S Wage =
Months or Weeks or Days in a Year
Budgeted Overheads × Lag in Overheads Payment
O/S Overheads =
Months or Weeks or Days in a Year
3.3 Cash Forecasting Method: This method is very much related to cash budgeting. It
attempts to estimate cash surplus or deficiency. For this purpose, streams of cash inflows
and outflows (expected in future period) are estimated. The surplus or deficiency indicated
by difference between receipts and payments is managed.

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Summary
Working capital management is a business tool that helps companies effectively make use of
current assets, helping companies to maintain enough cash flow to meet short term goals
and obligations. By effectively managing working capital, companies can free up cash that
would otherwise be trapped on their balance sheets. As a result, they may be able to reduce
the need for external borrowing, expand their businesses, fund mergers or acquisitions, or
invest in R&D. Working capital is essential to the health of every business, but managing it
effectively is something of a balancing act. Companies need to have enough cash available to
cover both planned and unexpected costs, while also making the best use of the funds
available.
Self check Questions
1. Write a detailed note on management of working capital.
2. Explain clearly various methods of working capital estimation.
3. Write short notes on: (a) Working capital cycle, and (b) Seed capital

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Practical problems on Estimation and Management of Working Capital

Illustration # 1: From the following information calculate operating cycle and estimate
working capital needs.
01.04.2019 31.03.2020
Raw Material 80,000 1,20,000
Work-in-Process 20,000 60,000
Finished Goods 60,000 20,000
Debtors 40,000 40,000
Wage & Manufacturing Expenses 2,00,000
Selling & Distribution Expenses 40,000
Purchase of Raw Material 4,00,000
Total Sales 10,00,000
All goods are sold on credit basis
Suppliers of material allow two months credit
Solution:
Average Stock of Raw Material
Raw Material Holding Period (R) =
Av. Raw Material Consumption Per Day
Material Consumed = (Opening Stock + Purchase – Closing Stock)
Material Consumed = (80,000 + 4,00,000 – 1,20,000) = 3,60,000
(80,000+1,20,000)/2
Raw Material Holding Period (R) = = 101.39 Days
3,60,000/365
Average Stock of WIP
WIP Holding Period (W) =
Average Cost of Production Per Day
Cost of Production = (Material Consumed + Wage & Manufacturing Expenses + Opening
Stock of Work-in-Process – Closing Stock of Work-in-Process)
Cost of Production = (3,60,000 + 2,00,000 + 20,000 – 60,000) = 5,20,000
(20,000+60,000)/2
WIP Holding Period (W) = = 28.08Days
5,20,000/365
Average Stock of Finished Goods
Finished Goods Holding Period (F) =
Average Cost of Sales Per Day
Cost of Sales = (Op. Stock of Finished Goods+ Cost of Production – Cl. Stock Finished Goods)
Cost of Sales = (60,000 + 5,20,000 – 20,000) = 5,60,000

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(60,000 + 20,000)/2
Finished Goods Holding Period (F) = = 26.07 Days
5,60,000/365
Average Book Debts
Debtors Collection Period (D) =
Average Credit Sales Per Day
(40,000+40,000)/2
Debtors Collection Period (D) = = 14.60 Days
10,00,000/365
Operating Cycle (O) = R + W + F + D − C
Operating Cycle (O) = (101.39 + 28.08 + 26.07 + 14.60 − 60) = 110.14 Days
Number of Days in a Year 365
Number of Operating Cycles = = = 3.31
Operating Cycle 110.14
Cost of Goods Sold = (Cost of Sales + Selling & Distribution Expenses)
Cost of Goods Sold = (5,60,000 + 40,000) = 6,00,000
Total Operating Cost or Cost of Goods Sold
Working Capital = + Desired Cash Balance
Number of Operating Cycles
6,00,000
Working Capital = = Rs. 1,81,268
3.31
Illustration # 2: Silverline, a newly setup enterprise, has furnished following cost data.
• Cost per unit (as % to sale price): Raw material – 40%, labor – 30%, Overheads – 10%
• Raw materials are expected to remain in stores for an average period of 1 month.
• Each unit of production will be in process for ½ month on average. Production in process
includes raw material – Full cost; Labor and overheads – Half of the cost.
• Finished goods are likely to stay in warehouse for an average period of 2 months.
• Half of the sale will be on credit basis, and customers are allowed 2 months credit.
• Credit period allowed by suppliers is 1 month.
• Lag in payment of wage is 1 month. Half of the overheads consist of salary to un -
productive staff.
• Firm maintains 20% of computed working capital as reserve for contingencies.
• Output level is 6,000 units, and Sales price is Rs. 200 per unit.
• Production and sales follow constant pattern.
Determine working capital requirements.

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Solution:
Calculation of Unit Cost:
Raw Material (40% of 200) : Rs. 80
Labor (30% of 200) : Rs. 60
Overheads (10% of 200) : Rs. 20
Work-in-Process (80 + 50% of 60 + 50% of 20) : Rs. 120
Finished Goods (80 + 60 + 20) : Rs. 160
Investment in Debtors (80 + 60 + 20) : Rs. 160
Statement of Estimated Working Capital
Amount (Rs.) Amount (Rs.)
Current Assets (A)
Raw Material (6,000 * 80 * 1/12) 40,000
Work-in-Process (6,000 * 120 * 1/24) 30,000
Finished Goods (6,000 * 160 * 2/12) 1,60,000
Debtors (20% of total Sales) (3,000 *160 * 2/12) 80,000 3,10,000
Current Liabilities (B)
Creditors (6,000 * 80 * 1/12) 40,000
Wage (6,000 * 60 * 1/12) 30,000 70,000
Net Working Capital (A – B) 2,40,000
Cash Balance for Contingencies (50% of 2,40,000) 48,000
Total working Capital Needs 2,88,000
Question # 3: The management of a company has called for a statement of working capital
to finance activity level of 1,80,000 units of output for the year. The unit cost structure of the
product at above mentioned activity level is: Raw Material – Rs. 20, Labor – Rs. 5, Overheads
(including depreciation of Rs. 5) – Rs. 15; and unit sale price is Rs. 50. The guidelines to follow
are:
• Raw materials are held in stock, on average for 2 months.
• Work-in-progress (assume 50% completion) will approximate to ½ s month’s
production.
• Cash sale is expected to be 25% of total sales.
• Finished stock remains in warehouse are held in stock, on average for 1 month.
• Customers are provided on average 2 months credit.
• Suppliers of raw materials extend 1 month’s credit.
• Time lag in payment of wage is 1 month, and ½ month in case of overheads.
• Minimum desired cash balance is Rs. 20,000.

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Solution:
Statement of Total Cost
Activity Level – 1,80,000 Units
Amount (Rs.)
Raw Material (1,80,000 * 20) 36,00,000
Labor (1,80,000 * 5) 9,00,000
Overheads (1,80,000 * 10) 18,00,000
Total Cost 63,00,000
Statement of Estimated Working Capital
Amount (Rs.) Amount (Rs.)
Current Assets
Raw Material (36,00,000 * 1/6) 6,00,000
Work-in-Progress (63,00,000/ 24) * 50% 1,31,250
Finished Goods (63,00,000/ 12) 5,25,000
Debtors (63,00,000/ 6) * 75% 7,87,500
Cash Balance 20,000 20,63,750
Current Liabilities
Creditors (36,00,000 * 1/12) 3,00,000
Direct Labor (9,00,000 * 1/12) 75,000
Overheads (excluding depreciation) (18,00,000 * 1/24) 75,000 4,50,000
Net Working Capital 16,13,750
Question # 4: Thapar Brothers started production of a classic toy on 1 January 2020. The
components of cost per unit include: Raw Material – Rs. 8, Wage – Rs. 12, and Variable
Expenses – Rs. 4. The fixed expenses per month are Rs. 15,000. Firm sells one -third of
produce for cash and rest of sale is on credit basis. The selling price of toy is Rs. 40 per unit.
As per terms settled with suppliers and customers (i) payment for materials is to be made in
the month following the month of purchase, and (ii) credit allowed to customers is one
month on average. Payment of expenses is made in the month in which they incur.
The output and sales from January to June 2020 is 900 units, 1,200 units, 1,800 units, 2,100
units, 2,250 units, and 2,550 units. Due to very low profit estimates in quarter ending on 31
March 2020, firm’s tax liability will be zero; but, in the next quarter ending on 30 June 2020,
it will have to pay corporate tax of Rs. 32,000 in the last week of June.
Firm does not maintain huge cash balance (preferably below Rs. 10,000). Accordingly, it
invests excess cash balance (in multiple of Rs. 5,000) in short term deposit schemes and get
them matured, when required.

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You are required to prepare a statement of cash forecast for a period from March to June
2020 assuming:
(i) Production and sale coincide, and
(ii) Opening cash balance as on 1 March 2020 is Rs. 3,800.
Solution:
Statement of Cash Forecast
(March 2020 – June 2020)
March April May June
(1800 Units) (2100 Units) (2250 Units) (2550 Units)
Opening Balance 3,800 6,400 9,400 7,600
Cash Receipts
Cash Sales (1/3 of Sale) 24,000 28,000 30,000 34,000
Collection from Debtors 32,000 48,000 56,000 60,000
Short-term Deposit Matured 10,000
Cash Available (A) 59,800 82,400 95,400 1,11,600

Cash Disbursements
Payment to Creditors 9,600 14,400 16,800 18,000
Payment of Wage 21,600 25,200 27,000 30,600
Payment of Variable Exp. 7,200 8,400 9,000 10,200
Payment of Fixed Expenses 15,000 15,000 15,000 15,000
Corporate Tax 32,000
Short-term Deposit 10,000 20,000
Cash Payments (B) 53,400 73,000 87,800 1,05,800
Closing Balance 6,400 9,400 7,600 5,800

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