Assessment and Computation of Working Capital Requirement
In case of a small-scale enterprise, the important factors determining the requirements of working capital are as follows:
Among the various factors, size of the sales is one of the important factors in determining the amount of working capital. In order to increase sales volume, the enterprise needs to maintain its current assets. In the course of period, the enterprise becomes in the position to keep a steady ratio of its current assets to annual sales. As a result, the turnover ratio, i.e., current assets to turnover increases reducing the length of operating cycle. Thus, less the operating cycle period, less will be requirements for working capital and vice versa.
2. Length of Operating Cycle:
Conversion of cash through various stages viz., raw material, semi-processed goods, finished goods, sales, debtors and bills receivables into cash takes a certain period of time that is known as ‘length of operating cycle’. Longer the operating cycle time, the more is the working capital required.
For example, heavy engineering needs relatively more working capital than a rice mill or cotton spinning mill or a steel rolling mill. Thus, it follows that depending upon the length of working cycle, the requirement for working capital varies from enterprise to enterprise.
3. Nature of Business
The requirement of working capital also varies among the enterprises depending upon the nature of the business. For instance, trading companies require more working capital than manufacturing companies. This is because that the trading business requires large quantities of goods to be held in stock and also carry large amounts of working capital than manufacturing concerns.
In both these types of businesses, the value of current assets is 80% to 90% of the value of total assets. The investment in current assets is relatively smaller in the case of hotels and restaurants because they mostly have cash sales, and only small amounts of debtors’ balances.
4. Terms of Credit
Another important factor that determines the amount of working capital requirements relates to the terms of credit allowed to the customers. For instance, an enterprise may allow only 15 days credit, while another may allow 90 days credit to its customers. Besides, an enterprise may extend credit facilities to its all customers, while another enterprise in the same business may extend credit only to select and those too reliable customers only.
Then, the requirements for working capital will naturally be more if the credit period is longer and credit facilities are extended to all customers, no matter reliable or non-reliable they are. This is because there will be longer balance of debtors and that too for a relatively longer period which will obviously demand for more capital.
On the contrary, if supplies of raw materials are available on favourable conditions or terms of credit i.e., the payment will be made after a relatively longer period of time, the requirement for working capital will be correspondingly smaller.
5. Seasonal Variations
The seasonal enterprises, i.e., the enterprise whose operations pick up seasonally may require more working capital to meet their increased operations during the particular season. A popular example of seasonal enterprise may be sugar factory whose operations are highly seasonal.
Turnover of Inventories
If inventories are large in size but turnover is slow, the small-scale enterprise will need more working capital. On the contrary, if inventories are small but their turnover is quick, the enterprise will need a small amount of working capital.
7. Nature of Production Technology
In case of labour intensive technology, the unit will need more amount to pay the wages and, therefore, will require more working capital. On the other hand, if the production technology is capital- intensive, the enterprise will have to make less payment for expenses like wages. As a result, enterprise will require less working capital.
If the demand for and price of the products of small- scale enterprises are subject to wide variations or fluctuations, the contingency provisions will have to be made for meeting the fluctuations. This will obviously increase the requirements for working capital of the small enterprises. While one can add certain other factors to this list, the said factors appear to be the major ones in determining the requirement of working capital of a small-scale enterprise.
Assessment of Working Capital:
The requirement for working capital of a small-scale enterprise needs to be assessed correctly as far as possible. Because, as we mentioned earlier both under and over working capitals are harmful for the enterprise. For example, over-estimation of working capital would result in blockage of scarce funds in idle assets.
On the other hand, under-assessment of working capital would deprive the enterprise of profitable opportunities. It is here that the concept of operating cycle of working capital reveals its sharpness. Let us explain it with an example.
Suppose the operating cycle of a small-scale enterprise is of four months. It means that the cycle of operations is repeated three times in a year. This further means that the enterprise would need an amount of working capital equal to one-third of the operating expenses of the whole last year.
This is best expressed by the following formula:
Total Working Capital Requirement = Total Operating Expenses in the Last Year/Number of Operating Cycles in the Year
In addition, if the prices go up in the coming year, a certain percentage for such contingencies will also be added to above working capital calculated so.
Method # 1. Percentage of Sales Method:
This method of estimating working capital requirements is based on the assumption that the level of working capital for any firm is directly related to its sales value. If past experience indicates a stable relationship between the amount of sales and working capital, then this basis may be used to determine the requirements of working capital for future period.
Thus, if sales for the year 2007 amounted to Rs 30,00,000 and working capital required was Rs 6,00,000; the requirement of working capital for the year 2008 on an estimated sales of Rs 40,00,000 shall be Rs 8,00,000; i.e. 20% of Rs 40,00,000.
The individual items of current assets and current liabilities can also be estimated on the basis of the past experience as a percentage of sales. This method is simple to understand and easy to operate but it cannot be applied in all cases because the direct relationship between sales and working capital may not be established.
Method # 2. Regression Analysis Method (Average Relationship between Sales and Working Capital)
This method of forecasting working capital requirements is based upon the statistical technique of estimating or predicting the unknown value of a dependent variable from the known value of an independent variable. It is the measure of the average relationship between two or more variables, i.e.; sales and working capital, in terms of the original units of the data.
Method # 3. Cash Forecasting Method
This method of estimating working capital requirements involves forecasting of cash receipts and disbursements during a future period of time. Cash forecast will include all possible sources from which cash will be received and the channels in which payments are to be made so that a consolidated cash position is determined.
This method is similar to the preparation of a cash budget. The excess of receipts over payments represents surplus of cash and the excess of payments over receipts causes deficit of cash or the amount of working capital required.
Method # 4. 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.
It involves purchase of raw materials and stores, its conversion into stock of finished goods through work-in-process with progressive increment of labour and service costs, conversion of finished stock into sales, debtors and receivables, realization of cash and this cycle continues again from cash to purchase of raw material and so on. The speed/time duration required to complete one cycle determines the requirement of working capital – longer the period of cycle, larger is the requirement of working capital and vice-versa.
The requirements of working capital be estimated as follows: