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WorkingCapitalEstimationOperatingCycleMethod
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Operating cycle method of working capital estimation is based on the duration of operating cycle.
Longertheperiodofthecycle,biggerwillbetheworkingcapitalrequirements.Operatingcyclemeans
thecycleofrawmaterialtoworkinprogresstofinishedgoodstoaccountspayableandfinallytocash.
Operatingcycletimeisthetimetakenstartingfromrawmaterialpurchasestoitsconversionintocash.

0:09/0:09

How to calculate or estimate working

capitalusingthismethod?
For calculating the working capital, we
would need 3 important things and they
have estimated cost of goods sold,
operating cycle time, and desired cash
levels.Thetimeofcyclecanbecalculated
usingoperatingcycleformula.
Formulaforcalculatingworkingcapital
requirementdirectlyisasfollows:
WorkingCapital={EstimatedCostof
GoodsSold*(OperatingCycle/365)}
+DesiredCashandBankBalance

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Calculatingthetotalworkingcapitalwillnot
sufficethepurpose.Howthisworking
capitalisformedisalsoimportant.It
meanseachcomponentofworkingcapitalwillhavetobeknown.Forthat,wewouldfirstneedthe
activitylevelofthecompanyunderreview.Letusseehowtocalculateeachitemofworkingcapital
below:
RawMaterial(RM)Stock:TheformulafordeterminingtheRMstockismentionedbelow.RMand
manyothercalculationsarebasedonestimatedproductionunitsandthereforeitshouldbecalculated
withutmostaccuracy.
EstimatedProductionUnits*PerUnitCostofRM*(RMHoldingPeriod/365Days)
WorkInProgress(WIP):IncalculatingtheWIP,specialcarehastobetakenofthepercentageof
laborandoverheads.Thesemayvarydependingonthestageoftheproductandcompletion
percentage.Wehavetakenthepercentageforanexample.

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accounting Negativeworking

EstimatedProduction*{PerUnitCostofRM(100%)+Labor(50%)+Overheads(50%)}*(WorkIn
ProgressPeriod/365Days)

capital Netpresentvalue

FinishedGoodsStock:InFinishedGoodsworkings,wehavetoknowthecostofproductionwiththe
helpofthepreviousyearcostsheetsorbudgetedcostsheetsofthecompanysproducts.

PaybackPeriod profit

Wealthmaximization

workingcapital
Workingcapital
financingworkingcapital

AccountsReceivables:Thiscalculationis
simpleandwejustneedtoputthe
estimatesandaveragecollectionperiod
right.

AccountsPayables:Thecalculationof
accountspayableissimilarbutthemajor
differenceisofrawmaterialcost.Wetake
finishedgoodssellingpriceinaccounts
receivablecalculationwhereasraw
materialcostincaseofaccountspayable.

maximization risk sourcesof

financetermloantrade
creditvalueofafirmWACC

EstimatedProduction*PerUnitCostof
GoodsProduced*(FinishedGoods
HoldingPeriod/365Days)

EstimatedProduction*SellingPrice*
(CollectionPeriod/365Days)

netprofitNPV

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EstimatedProduction*PerUnitRMCost*(PaymentPeriod/365Days)

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AdvantagesandDisadvantagesofOperatingCycleMethodofWorkingCapitalCalculations
Theadvantageisthatitisadetailedmethodandbasedontheactualeconomicconditionsprevailingin
themarket.Itgivesadetailedunderstandingofthebusinessaswellanditisprecisecomparedtoother
methods.Thedisadvantageisthatitisalengthyprocesstoarriveatacomponentwisecalculationof
workingcapital.Itneedsalotofestimatelikeestimatedproduction,holdingperiodofinventory,
collectionandpaymentperiod,etc.So,itisariskymatter.Thereareprobablechancesofgoingwrong
inestimatingthesedataandthatmayhurtthewholeprocess.Itisadvisabletokeepacushionwhile
estimatingthingsonthedarkerside.

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11/6/2016

WorkingCapitalEstimationOperatingCycleMethod|eFinanceManagement
OtherMethodsforEstimatingthe
WorkingCapitalRequirements:
PercentageofSalesMethod
RegressionAnalysisMethod
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