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There are broadly three methods of estimating or analyzing the requirement of working capital of a company viz. percentage of revenue or sales, regression analysis, and operating cycle method. Estimating working capital means calculating future working capital. It should be as accurate as possible because the planning of working capital would be based on these estimates and bank and other financial institutes finance the working capital needs to be based on such estimates only.
3 Methods of Estimating / Analyzing Working Capital are as follows:
It is the easiest of the methods for calculating the working capital requirement of a company. This method is based on the principle of ‘history repeats itself’. For estimating, a relationship of sales and working capital is worked out for say last 5 years. If it is constantly coming near say 40% i.e. working capital level is 40% of sales, the next year estimation is done based on this estimate. If the expected sales are 500 million dollars, 200 million dollars would be required as working capital.
The advantage of this method is that it is very simple to understand and calculate also. Disadvantage includes its assumption which is difficult to be true for many organizations. So, where there is no linear relationship between the revenue and working capital, this method is not useful. In new startup projects also, this method is not applicable because there is no past.
This statistical estimation tool is utilized by mass for various types of estimation. It tries to establish trend relationship. We will use it for working capital estimation. This method expresses the relationship between revenue & working capital in the form of an equation (Working Capital = Intercept + Slope * Revenue). The slope is the rate of change of working capital with one unit change in revenue. Intercept is the point where regression line and working capital axis meets (Will not go deeper into statistical details). At the end of the statistical exercise with past revenue and working capital data, we will get an equation like below:
Working Capital = -6.34 + 0.46 * Revenue
To calculate working capital, just put the targeted revenue figure in the above equation, say 200 million dollars.
Working Capital = -6.34 + 0.46 * 200 = -6.34 + 92 = 85.66 ~ 86 Million Dollar.
Therefore, we need 86 million dollars of working capital to achieve revenue of 200 million dollars.
This is probably the best of the methods because it takes into account the actual business or industry situation into consideration while giving an estimate of working capital. A general rule can be stated in this method. Longer the working capital operating cycle, higher would be the requirement of working capital and vice versa. We would agree to the point also. The following formula can be used to estimate or calculate the working capital
Working Capital = Cost of Goods Sold (Estimated) * (No. of Days of Operating Cycle / 365 Days) + Bank and Cash Balance.
If the cost of goods sold (estimated) is $35 million and operating cycle is 75 days and bank balance required is 1.25 million. Therefore, Working Capital = 35 * 75/365 + 1.25 = $8.44 Million.
In this method, each component can also be calculated. It means bifurcation of $8.44 million can be done in inventory, cash, accounts receivable, accounts payable etc.