Estimating Working Capital Requirements

True Tamplin

Written by True Tamplin, BSc, CEPF®
Updated on September 16, 2021

1. Estimating Working Capital Requirement Using Operating Cycle Method

Problem

X Ltd Co. wants to estimate its working capital using the operating cycle method when:

  • Estimated sales 20,000 units @ $5 P.U.
  • Production and sales will remain similar throughout the year
  • Production costs: Materials – 2.5 P.U., Labor 1.00 P.U., Overheads $17,500

Customers are given 60 days of credit and 50 of days credit from suppliers. The 40-day supply of raw materials and a 15-day supply of finished goods are kept in store.

The production cycle lasts 20 days. All materials are issued at the start of each production cycle. One-third of the average working capital is kept as a cash balance for contingencies.

Solution

Total Op. Exp. For the Year $
R.M. 20,000 x 250 50,000
Labor 20,000 x 1 20,000
Overheads 17,500
87,500
Period of Production cycle Days
Material storage days (pds.) 40
Finished goods storage (pds.) 15
Production cycle storage (pds.) 20
Av. collection (pds.) 60
135
Less: average payment (crs.) 50
85

(c) No. of operating cycles in the year = 365 / 85 = 4.3
(d) Working capital = 87,500 / 4.3 = $20,349
Add: Reserve for contingencies 1 / 3 = 6,789 / $27,132

2. Using Working Capital Method

Problem

$
Raw materials (needed) 10,000
Store value 16,000
Average credit givers:
Local sales 2 weeks credit 1,56,000
Outside sales 6 weeks credit 6,24,000
Time lag payment:
For purchase (4 weeks) 1,92,000
For wages (2 weeks) 5,20,000

Contingencies allowances = 15%

Required: Calculate the amount of working capital.

Solution

Current Assets

Inventories: R.M. $10,000
Stock of Store $16,000 $26,000

Account Receivables (Drs)
Local sales = (1,56,000 x 2) / 52 = $6,000
Outside sales = (6 x 6,24,000) / 52 = $72,000
Less: Current Liabilities
Accounts Payables (Crs.) = (1,92,000 x 4) / 52 = $14,770
O/S Wages = (5,20,000 x 2) / 52 = $20,000
Add: 15% for contingencies = 10,385
Total working capital required = $79,615

3. Using Cash Forecasting Method

Problem

John Trading Co. has asked you to prepare a working capital forecast using the following information:

  • Issued share capital: $400,000
  • 8% deb.: $1,50,000
  • Fixed assets are valued at $300,000
  • Production: 100,000 units.
  • Expected ratios of cost to selling price are: R.M. 50%, Wages: 10%, Overheads: 25% = 85%

Raw materials remain in stores for 2 months, finished goods remain in stores for 4 months, the credit allowed by crs. is 3 months from the date of delivery of goods (Rm), and the credit given to Drs. is 3 months from the date of dispatch.

The production cycle is 2 months. Additionally, the sale price per unit is $6, and production and sales are uniform throughout the year.

Solution

Estimating Working Capital Requirements

4. Using Projected Balance Sheet Method

Problem

Libro Ltd. has $350,000 share capital, $70,000 G.R., $300,000 fixed assets, $30,000 stock, $97,500 Drs., and $15,000 Crs.

The company proposes increasing the business stock level by 50% at the end of the year. Credits are doubled and it is proposed that machinery worth $15,000 should be purchased.

Estimated profit during the year is $52,500 after changing $30,000 depreciation and 50% of profit for taxation. Advance income tax is estimated at $45,000. Credits are likely to be doubled, 5% dividends will be paid, and 10% dividends are to be proposed for the next year.

Drs. are estimated to be outstanding for 3 months. The sales budget shows $750,000 as sales for the year to make a working capital forecast by the projected balance sheet method.

Solution

(i) Sh. cap. Fixed assets 300,000
Cap. (Given) 350,000 350,000 M. proposed purchase 15,000
Res. and surplus 70,000 Less dep. 315,000
17,500 30,000
Less dividend 10% 52,500 285,000
52,500 C.A.
+ Profit after tax 105,000 70,000 Stock 30,000 + 50% add. drs. 15,000 45,000
Less proposed div. 10% 35,000 Adv. tax 45,000 187,500
Current liabilities 277,500
Crs. 15,000
+ (k) 15,000 30,000
Tax provision 52,000
Proposed div. 35,000
O/D (balance figure) 25,000 170,500
562,500 562,000

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True Tamplin, BSc, CEPF®

About the Author
True Tamplin, BSc, CEPF®

True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.

True contributes to his own finance dictionary, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.

To learn more about True, visit his personal website, view his author profile on Amazon, his interview on CBS, or check out his speaker profile on the CFA Institute website.

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