Estimating Working Capital Requirement

Operating Cycle Method:

This method of estimating working capital
requirements is based upon the operating cycle
concept of working capital. The cycle starts with
the purchase of raw material and other resources
and ends with the realization of cash from the
sale of finished goods after cash and credit sales.
For proper computation of working capital under
this method, a detailed analysis is made for each
individual component of working capital i.e.
current asset and current liabilities.
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Operating and Manufacturing Cycle

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Statement of Working Capital Requirement
Estimation of Current Assets and Current Liabilities Amount (₹)
Current Assets:
Stocks of raw material, work in process & finished goods

Debtors/Receivables
Cash
Others
Less: Current Liabilities
Creditors Bills payable
Outstanding expenses
others
Working Capital (CA-CL)
Add: Provision/Margin for contingencies

Net Working Capital Required

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Computing the Value of Items of CA and CL
The value of each individual item of current assets and current
liabilities is determined on the basis of estimated sales or
budgeted production or activity level as follows:
Estimating the values of Current Assets
(a) Stock of Raw Material:
The amount of working capital funds to be invested in holding
stock of raw material can be estimated on the basis of budgeted
units of production, estimated cost of raw material per unit and
the average duration for which the raw material is held in stock
by using the following formula:
Estimated value of Stock of Raw Material=
Budgeted Units of Production x Cost per unit x Average holding
period in months or weeks or days/No. of months or weeks or
day in a year
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Question on estimating the value of Stock of Raw Material
Question 1
You are given the following information regarding the stock of raw
material:
1. Proposed level of activity of production and sale is 1,44,000 units.
2. Cost per unit of raw material is ₹45.
3. Raw materials are expected to remain in stock for a period of two
months.
Required:
Estimate the working capital component of stock of raw material.
Solution:
Estimated value of Stock of Raw Material
=Budgeted Units of Production x Cost per unit x Average holding
period in months or weeks or days/No. of months or weeks or day in a
year
=1,44,000x45x2/12
=₹ 10,80,000 (Answer)
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Estimating the Value of Current Assets (cont…)
(b) Stock of Work-in-Process:
In manufacturing/processing industries the production is carried on continuous
basis. At the end of the period, some work remains incomplete even though all
or some expenses have been incurred, this work is known as work-in-progress.
The work-in-process consists of direct material, direct labor and production
overheads locked up in these semi-finished goods.
The amount of funds estimated to be invested in work-in-process may be
computed as:
Estimated value of Stock of WIP=
Budgeted Units of Production x Cost per unit x Average holding period in
months or weeks or days/No. of months or weeks or day in a year
Note:
1. In the absence of information about stage of completion of WIP with regard
to material labor and overheads, 100% of material cost, and 50% of labor and
production overheads cost may be assumed as the estimated cost of work-in-
process.
2. In case cash cost approach’ is followed for estimation of working capital,
then depreciation should be excluded from production overheads while
calculating cost of work-in-process. However, under the total approach,
depreciation is also included.
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Question on estimating the value of Work-in-Progress
Question 2
You are given the following information regarding the work-in progress:
1. Proposed level of activity of production and sale is 1,44,000 units.
2. Cost per unit of:
a) raw material ₹45
b) direct labor 20
c) Overheads 40
Total cost 105
3. Materials are in process on an average of one month. The degree of
completion is 50% in respect of all elements of cost.
Required:
Estimate the working capital component of stock of raw material.
Solution:
Estimated value of Stock of Raw Material=
Budgeted Units of Production x Cost per unit x Average holding period in
months or weeks or days/No. of months or weeks or day in a year
=1,44,000x105x0.5x1/12
=₹6,30,000 (Answer)
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Estimating the Value of Current Assets (cont…)
(c) Stock of Finished Goods:
The amount of funds to be invested in holding stock of finished
goods can be estimated on the basis of annual budgeted units of
production, estimated cost of production per unit and the average
holding period of finished goods stock by using the following
formula:
Estimated value of Stock of Finished Goods=
Budgeted Units of Production x Cost per unit x Average holding
period in months or weeks or days/No. of months or weeks or
day in a year
Note:
(i) Cost of production consist of 100% of material, labor and
production overheads costs.
(ii) Under the total cost approach, depreciation is included in the
cost of goods produced. However, depreciation is to be excluded
under the cash cost approach.
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Question on estimating the value of Stock of Finished Goods
Question 3
You are given the following information regarding the stock of finished goods:
1. Proposed level of activity of production and sale is 1,44,000 units.
2. Cost per unit of:
– raw material ₹45
– direct labor 20
– Overheads 40
Total cost 105
3. Finished goods are in stock on an average of one month.
Required:
Estimate the working capital component of stock of finished goods.
Solution:
Estimated value of Stock of finished goods=
Budgeted Units of Production x Cost per unit x Average holding period in
months or weeks or days/No. of months or weeks or day in a year
=1,44,000x105x1/12
=₹12,60,000 (Answer)
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Estimating the Value of Current Assets (cont…)
(d) Investment in Debtors/Receivables:
When the sales are made by a firm on cash basis, the amount is realized
immediately and no funds are blocked after sale period. However, in case of
credit sales, there is a time lag between sales and realization of cash. Thus,
funds are to be invested in receivables, i.e. debtors and bills receivables.
However, actual amount of funds locked up in receivables is only to the extent
of cost of sales and not the actual sales which include profit. The cost basis
estimation of debtors is more reasonable. But in case, total approach is
followed for estimation of working capital then receivables may be computed
on the basis of selling price.
Estimated value of Stock of Debtors/Receivables=
Budgeted Units of Production x Cost per unit x Average holding period in
months or weeks or days/No. of months or weeks or day in a year
Note:
Debtors/Receivables are to be estimated on cost basis rather than on price basis.
However, under total approach the debtors/receivables may be estimated on
sale price basis

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Question on estimating the value of Debtors/Receivables
Question 4
You are given the following information regarding the stock of finished goods:
1. Proposed level of activity of production and sale is 1,44,000 units.
2. Cost per and selling price per unit of:
Raw material ₹45
Direct labor 20
Overheads 40
Total cost 105
Profit 15
Selling Price 120
3. 20% of sales are made in cash
4. Cash is recoverable from debtors on an average of two months after the credit sales.
Required:
Estimate the working capital component of stock of debtors.
Solution:
Estimated value of Debtors=
Budgeted Units of Production x Cost per unit x Average holding period in months or
weeks or days/No. of months or weeks or day in a year
=1,44,000x105x0.8x2/12
=₹20,16,000 (Answer)
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Estimating the Value of Current Assets (cont…)
(e) Cash and Bank Balance:
Cash is one of the current assets of a business. It is
needed at all times to keep the business going. A
business firm has always to keep a sufficient cash to
meet its obligations. Thus, a minimum desired cash
and bank balance to be maintained by a firm should
be considered as an important component of current
assets while estimating the working capital
requirements.
For example, A cash balance of ₹1,00,000 or
₹2,00,000 can be decided to maintain depending the
prevailing business situation.
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Estimating the Value of Current Liabilities
(a) Trade Creditors:
trade creditors refer to the creditors for purchase of
raw material, consumables, stores etc. The suppliers
of goods, generally, extend some period of credit in
the normal course of business. The trade credit
arrangement of a firm with its suppliers is an
important source of short-term finance. It reduces the
amount of net working capital required by a firm. The
amount of funds to be provided by creditors can be
estimated as follows:
Estimated Value of Creditors = Budgeted Units of
Production x Cost per unit x Average payment period
of creditors in months or weeks or days/No. of months
or weeks or days in a year
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Question on estimating the value of Trade Creditors
Question 1
On the basis of the following information provided to you,
compute the value of trade creditors:
1. Proposed level of activity of production and sale is
1,44,000 units.
2. Cost per unit of raw material ₹45
3. Credit allowed by suppliers is one month.
Solution:
Estimated value of Trade Creditors=
Budgeted Units of Production x Cost per unit x Average
payment period for creditors in months or weeks or
days/No. of months or weeks or day in a year
=1,44,000x45x1/12
= ₹ 5,40,000 (Answer)
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Estimating the Value of Current Liabilities (Cont…)
(b) Creditors for Wages and Other Expenses:
Wages and salaries are usually paid on monthly, fortnightly or weekly
basis for the services already rendered by employees. The longer the
payment period, the greater is the amount of current liability towards
employees or the funds provided by them. In the same manner, other
expenses may also have to be paid after the lag of a certain period. The
amount of such outstanding expenses reduces the level of net working
capital requirements of a firm.
The creditors for wages and other overheads may be computed as
follows:
Estimated value of Creditors and Other Expenses=
Budgeted Units of Production x Cost per unit x Average payment
period for creditors in months or weeks or days/No. of months or
weeks or day in a year
Note:
(i) The creditors for wages and each of the overheads may be calculated
separately.
(ii) In case of selling overheads, budgeted annual sales in units should
be considered in place of budgeted production units,
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Question on estimating the value of Creditors for Expenses
Question 2
On the basis of the following information provided to you,
compute the value of trade creditors:
1. Proposed level of activity of production and sale is 1,44,000
units.
2. Cost per unit of direct labor is ₹20 and cost per unit of
overheads is ₹40
3. Time lag in payment of wages and overhead is 1½ weeks.
Solution:
Estimated value of Creditors for wages and overheads=
Budgeted Units of Production x Cost per unit x Average payment
period for creditors in months or weeks or days/No. of months or
weeks or day in a year
=1,44,000x60x1.5/48
=₹ 2,70,000 (Answer)

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Question on working capital estimation
The following information is available from the records of Company X Ltd:
Product Cost Sheet per unit (₹):
Raw material 45
Direct labor 20
Overheads 40
Total 105
Add Profit 15
Selling price 120

Additional information:
1. Raw materials are in stock on an average for two months.
2. Materials are in process on an average of one month. The degree of completion is 50% in respect of all
elements of cost.
3. Finished goods are in stock for an average of one month.
4. Time lag in payment of wages and overheads is 1½ weeks.
5. Time lag in receipt of proceed from debtors is 2 months.
6. Credit allowed by suppliers is one month.
7. 20% of output is sold against cash.
8. The company expects to keep a cash balance of ₹ 1,00,000 .
9. The firm expects to manufacture 1,44,000 units in next year.
10. 10% provision of working capital for contingency is to be created.
You are required to prepare a statement of working capital requirement of the company for next year.
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Statement of Working Capital Requirement
Current Assets Amount(₹ ) Amount(₹)
Stock of Raw Material = 1,44,000x45x2/12 10,80,000
Work in progress =1,44,000x105x1/12x1/2 6,30,000
Finished goods=1,44,000x105x1/12 12,60,000
Debtors =144,000x105x0.8x2/12 20,16,000
Cash Balance 1,00,000 50,86,000
Current Liabilities
Creditors for raw materials=1,44,000x45x1/12 5,40,000
Creditors for wages & overheads
=1,44,000x 60x1.5/48 2,70,000 8,10,000
Working Capital (CA-CL) 42,76,000
Add: 10% Margin of WC for Contingency 4,27,600
Net Working Capital 47,03,600
Working Notes:
1. Debtors have been estimated at cost.
2. One month has been taken to contain 4 weeks

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