The document discusses methods for estimating working capital requirements using the operating cycle approach. It explains that the operating cycle consists of the time from purchasing raw materials to converting them into cash from sales. The longer the operating cycle, the greater the working capital needs. It then outlines how to calculate working capital requirements for various current asset and liability line items, including raw materials, work-in-progress, finished goods, receivables, cash, creditors, and outstanding expenses. Steps provided include identifying relevant line items, determining average holding periods, unit costs, and amounts blocked in each line item to calculate total working capital needs.

1. Working Capital Estimation –
Operating Cycle Method
• Operating cycle method for estimating working
capital is based on the duration of the operating
cycle.
• The longer the period of the cycle, the bigger will
be the working capital requirements.
• Operating cycle means the cycle of raw material
to work in progress to finished goods to accounts
receivables and finally to cash.
• Operating cycle time is the time taken starting
from raw material purchases to its conversion
into cash.

2. • Need for Cash and Bank Balance : Every firm
must maintain some minimum cash and bank
balance (i.e., immediate liquidity) to meet day to
day requirement for petty expenses, general
expenses and even for cash purchases. The
minimum cash requirement for these
transactions can be estimated on the basis of
past experience.
• The minimum cash and bank balance is also
considered while preparing the cash budget for
the firm.

3. • Need for Raw Materials : Depends upon various factors
such as raw material consumption rate, time lag in
procuring fresh stock, contingencies and other factors.
• e.g. if it takes 5 days to procure fresh stock of raw
materials, and 50 units are used daily, then there should be
a minimum of 250 units in stock.
• The firm may also like to have a safety stock of 20 units.
Thus, the total units to be maintained in stores would be
270 units.
• If the cost per unit of this item of raw material is Rs. 10 per
unit, then the working capital requirement is Rs. 2,700 (i.e.,
270 × Rs. 10).

4. • Need for Work-in-progress : All the units are not equally
completed and hence valuation of all these units is a
difficult job. For this purpose, certain assumptions may be
made as follows :
• (i) The production process starts with the intake of full raw
material. So, the value of raw material locked up in work-in-
progress will be equal to full cost of number of units of raw
material being represented in work-in-progress.
• (ii) The units in work-in-progress may be unfinished with
respect to labour expenses and overhead expenses only.
• It is assumed for simplification, that all work-in-progress
units are on an average 50% complete with respect to
labour and overhead expenses.

5. Need for Finished Goods: In most of the cases, be it a trading
concern or a manufacturing concern, the goods are not
immediately sold after purchase/procurement/completion of
production process. The goods in fact, remain in stores for some
times before they are sold.
The cost which is already incurred in purchasing, procuring or
production of these units is locked up and hence working capital
is required for them. It may be noted that these finished goods
are valued on the basis of cost of these units. The carriage
inward of course, is included.

6. • Need for Receivables : In case of credit sales,
there is a time lag between sales and
collection of sales revenue.
• e.g. a firm makes a credit sale of Rs. 1,50,000
per month and a credit of 15 days given to
customers. The working capital locked up in
receivables is Rs. 75,000 (Rs. 1,50,000 × 1/2
month).

7. • Creditors for the Purchases : The suppliers of
the firm in fact provide working capital to the
firm for the credit period.
• For example, a firm makes credit purchases of
Rs. 60,000 per month and the credit allowed
by the suppliers is two month, then the
working capital supplied by the creditors is Rs.
1,20,000 (i.e., Rs. 60,000×2 months).

8. • Creditors for Expenses and Wages: The time lag
in payment of wages and other expenses also provide some
working capital to the firm.
• The wages and expenses are considered for the valuation of
work-in-progress and finished goods, but are paid usually at
the end of the month, providing a working capital to the firm
for that period.

9. Steps in estimation of Working capital
• Identify the current assets and current liabilities to be maintained. Each element.
• Determine the average operating cycle (or holding period) for each of these
elements.
• Find out the rate per unit for each of these elements.
• Find out the amount (funds) expected to be blocked in each of these elements.
E.g., the funds blocked in raw materials is:
Av. holding period × No. of units required Per Period × Rate per unit.
• Prepare the working capital estimation sheet and find out the working capital
requirement.

10. Working Capital = Current Assets – Current Liabilities
= (Raw Material Stock + Work-in- progress Stock +
Finished Goods Stock + Debtors + Cash Balance) –
(Creditors + Outstanding Wages + Outstanding
Overheads),
where,
Raw Material Stock
= Cost (Average) of Materials in Stock.
Work-in-progress Stock
= Cost of Materials + Wages + Overhead of Work-in-
progress.
Finished Goods Stock Creditors for Material
= Cost of Materials + Wages + Overhead of Finished
Goods.
Creditors for Materials = Cost of Average Outstanding Creditors.
Creditors for Wages = Average Wages Outstanding.
Creditors for Overhead = Average Overheads Outstanding.
Thus, Working Capital
= Cost of Materials in Stores, in Work-in-progress,
in Finished Goods and in Debtors. Less : Creditors
for Materials. Plus : Wages in Work-in-progress, in
Finished Goods and in Debtors.
Less : Creditors for Wages.
Plus : Overheads in Work-in-progress, in Finished
Goods and in Debtors. Less : Creditors for
Overheads.

11. Estimation of Working Capital Requirements
I Current Assets : Amount Amount Amount
Minimum Cash Balance ****
Inventories :
Raw Materials ****
Work-in-progress ****
Finished Goods **** ****
Receivables :
Debtors ****
Bills **** ****
Gross Working Capital
(CA)
**** ****
II. Current Liabilities :
Creditors for Purchases ****
Creditors for Wages ****
Creditors for Overheads ****
Total Current Liabilities
(CL)
**** ****
Excess of CA over CL ****
+ Safety Margin ****
Net Working Capital ****
equirements

12. Other points to be considered
– Depreciation : The depreciation is a non-cash
expense and there is no funds locked up in
depreciation as such and therefore, it is ignored.
– Safety Margin : Sometimes, a firm may also like to
have a safety margin of working capital in order to
meet any contingency. The safety margin may be
expressed as a % of total current assets or total
current liabilities or net working capital.

13. The cost sheet of XYZ ltd.provides the following data:
Particular’s Cost per unit
Raw material Rs. 50/-
Direct labor Rs. 20/-
Overheads (including depreciation of Rs.10/-) Rs. 40/-
Total Cost Rs. 110/-
Profits Rs. 20/-
Selling price Rs. 130/-
Average raw material in stock is for one month.
Average material in work in progress is for half month.
Credit allowed by suppliers one month.
Credit allowed to Debtors one month, 75% sales are on credit basis
Lag in payment of wages 10 days
Lag in payment of Overheads 30 days.
Cash Balance 1,00,000/- Yearly Production 54000 Units

14. • Estimation of WC Requirement
I. Current Assets : Amt. Amt.
Min. Cash bal. 100000
Raw mtrl (4500x50) 225000
WIP:
Mtrl (4500x50)/2 112500
Wages 50%(4500x20)/2 22500
Overhead50%(4500x30)/2 33750
Finished Goods(4500x100) 450000
Debtors (4500x100x75%) 337500
Gross WC 12,81,250

15. II. Current Liabilities
Creditors for Mtrl (4500x50) 225000
Creditors for Wages (4500x20)/3 30000
Creditors for overheads (4500x30) 135000
Total Current Liabilities 390000
Net WC (12,81,250 - 390000) = Rs. 891250

16. • Average raw material holding period is 20
days, cost per unit is Rs.30. Daily production is
1000 units, the funds blocked in raw material
are:
• A. Rs. 300000
• B. Rs. 500000
• C. Rs. 600000
• D. Rs. 400000

17. • Average raw material holding period is 20
days, cost per unit is Rs.30. Daily production is
1000 units, the funds blocked in raw material
are:
• A. Rs. 300000
• B. Rs. 500000
• C. Rs. 600000
• D. Rs. 400000

18. • If the creditors for wages agree to increase the
lag period, the working capital requirements
would increase?
• True
• False

19. Thank You