Friday, January 27, 2017

Estimating Working Capital Requirement

Now that you know why working capital is critically important to keep an organization running, the next step is to estimate how much you need. Hypothetically speaking, if all transactions were in cash and done with no time lag, the working capital requirement would be zero.
To illustrate this point, let’s suppose a company buys goods for $100 from A and at the same instant sells the entire stock to B for $250. It makes a gain of $150 without holding any stock or even, needing cash because there is no time lag between the two transactions. Therefore, its working capital requirement is zero.

Now consider what happens to the same company if it buys for money from a banker, holds $500 as stock for 1 month, and sells to the consumer on 60-day credit terms. The company that started with zero in the banking account had to locate the finance to fund the stock. During this time, its working capital requirement is $500. After 1 month, it sells goods costing $100 to a person for $250. Its stock falls to $400, but now it should wait sixty days to receive the $250 from the consumer. The working capital changes to the stock of $400 and the sum due from the consumer of $250, making it a total of $650. In case the supplier of stock gave a 45-day credit, for the first 45 days the company wouldn't need to pay for the goods held in its stock and its working capital needs would fall by the sum due to the provider. This examples refers to a one-time operating cycle. However, in real life, these transactions – borrowing, purchasing, processing and sales - are ongoing. Therefore, working capital requirement is estimated on period averages rather than the as-on-date balance sheet figures.

There are various methods to budget working capital needs, the most common ones being – percentage of sales, operating cycle basis and regression. The first method forecasts sales for the plan period and each element of current assets and current liabilities is calculated as a percentage of sales. The percentages are usually averages of historical rates. The second method is by far the most comprehensive calculation. Each element is separately calculated in detail, taking into account all the factors affecting it. For instance, to forecast Accounts Receivable (debtors), first historical Average Debtor Days is calculated as (Average AR*365) / (Period Credit Sales). This formula is used for annual projections; for quarter, it will be 90 days and so on. Next, AR is forecasted as (Average Debtor Days*Projected Period Credit Sales) / 365. The third is a statistical method. In this case, the historical relationship between sales and working capital is plotted on a regression line with equation as

             Working Capital = Slope of the Line*Sales + Constant or Line Intercept

The working capital figure is arrived at by substituting the value of projected sales in this equation.

Generally, we may see that the working capital need increases as stock and amounts owing by clients increase, and reduces as the sums owed to providers increases. As the company grows quickly, its own sales increase, which in turn increases the accounts receivables due from clients and the amount of stock they need to hold. This rapid escalation in working capital requirement may cause a business to go out of money unless there is adequate finance set up to cope with the growth. This is why financial management with expert help is advised whether you are starting your business or expanding. Many small businesses make the mistake of de-emphasizing financial planning and analytics that can lead to serious implications. Don't be one of them. Let us know your requirements at contact@eurionconstellation.com. Know more about us at www.eurionconstellation.com

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