Determination of working capital requirement is one of the major short-term planning which plays very vital role for operating the business successfully. The determination of working capital is to be done very effectively otherwise there may be over or under estimation of working capital. The amount of working capital should be sufficient. Following two methods can used to determine the amount of working capital:
1. Projected Balance Sheet Method
2. Operating Cycle Method
1. Projected Balance Sheet Method
It is the conventional method of calculating working capital. Total current assets and current liabilities are taken into account to calculating working capital. All the data given in balance sheet regarding current assets and current liabilities are taken into consideration for estimating the working capital. Total current liabilities is deducted from total current assets to obtain the amount of net working capital under this method.
Net Working Capital = Total Current Assets - Total Current Liabilities
2. Operating Cycle Method
Time which is needed to convert raw material into finished goods, finished goods into sales and account receivable into cash is called operating cycle. Under operating cycle method, time needed for different types of current assets and time lag needed for payment of purchase and expenses are considered to compute requirement of working capital. The items of current assets and current liabilities are calculated as follows:
* Raw material inventory
= (Annual output x material cost per unit x inventory holding period)/Total Periods
* Work-in-progress Inventory
= (Annual output x Manufacturing cost per unit x Inventory holding period)/Total periods
* Finished Goods Inventory
= (Annual output x total cost per unit x inventory holding period)/Total periods
* Account Receivable(Debtors)
= ( Annual credit sales units x total cost per unit x credit period allowed)/Total periods
* Prepaid Expenses
= (Annual Expenses x Advance Period)/Total periods
* Account Payable (Creditors)
= (Annual output x raw material cost per unit x credit period)/Total periods
* Outstanding Wages
= (Annual output x labor cost per unit x time lag)/ Total periods
* Outstanding Overhead
= (Annual output x overhead per unit x time lag)/Total periods
* Outstanding Expenses
( Annual expenses x Time lag)/ Total periods
Notes:
a. Current assets and current liabilities should be estimated on cash cost basis.
b. Non-cash expenses like depreciation should be excluded from overhead.
c. Finished goods and debtors should be valued on total cost basis.
d. Work-in-progress is valued on total cost basis unless percentage completion stage is not mentioned.
e. If the time lag in payment of expenses is not given, there is no need to keep the expenses in the list of current liabilities.
f. If stock holding period is given, there is no need to calculate stock of finished goods, work-in-progress and raw materials.
g. Calculation of debtors should be made on the basis of credit sales.
h. Calculation of creditors should be made on the basis of credit purchase.
