Describe the steps involved in estimating the working capital requirement of a firm.
Answers
The methods involved in estimating the working capital requirement of a firm are:
1. Working capital as a percentage of net sales
This approach is based on the fact that the working capital for any company is directly related to the volume of sales of that company. So the working capital requirement is expressed as a percentage of the sales expected during a particular period. It is based on the assumption that if the sales level is high more working capital will be needed.
There are three steps -
a. Estimate total current assets as a percentage of estimated net sales.
b. Estimate current liabilities as a percentage of estimated net sales.
c. Calculate the difference between the two of them mentioned above.
This will give the net working capital as a percentage of net sales.
2. Working capital as a percentage of total assets or fixed assets
This approach is based on the fact that the total assets of a company consist of fixed assets and current assets. A relationship between the gross working capital or net working capital and total fixed assets of the company is established on the basis of past experience.
3. Working capital based on operating cycle
In this approach each component of working capital is analyzed in detail and an estimation is made for each component.