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Estimation of Financial Requirements

1. Definition

Estimation of Financial Requirements is the process of determining the quantum of funds needed by a business for its operations, expansion, and growth, both for fixed capital (long-term) and working capital (short-term) needs.

2. Types of Financial Requirements

2.1 Fixed Capital Requirements

Purpose: Long-term investments in fixed assets.

Components:

  • Land and buildings
  • Plant and machinery
  • Furniture and fixtures
  • Vehicles

Estimation Method: Based on expansion plans, technology needs, and production capacity targets.

2.2 Working Capital Requirements

Purpose: Day-to-day operations.

Components:

  • Current Assets: Cash, inventory, receivables
  • Current Liabilities: Payables, short-term loans

Formula:

Formula

Working Capital = Current Assets - Current Liabilities

Gross Working Capital = Total Current Assets

Net Working Capital = Current Assets - Current Liabilities

3. Factors Determining Financial Requirements

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4. Estimation Methods

Method 1: Operating Cycle Method

Concept: Estimate funds needed based on operating cycle.

Operating Cycle = Inventory Period + Receivables Period

Example Problem:

Given:

Average Inventory holding period: 60 days
Average collection period: 30 days
Average payment period: 45 days
Annual Operating Costs: ₹36,50,000

Find: Working capital requirement

Solution:

Step 1: Calculate Operating Cycle

Operating Cycle = Inventory Period + Receivables Period
= 60 days + 30 days
= 90 days

Step 2: Calculate Cash Cycle

Cash Cycle = Operating Cycle - Payment Period
= 90 days - 45 days
= 45 days

Step 3: Calculate Daily Operating Cost

Daily Cost = Annual Cost / 365
= ₹36,50,000 / 365
= ₹10,000 per day

Step 4: Calculate Working Capital Requirement

Working Capital = Daily Cost × Cash Cycle
= ₹10,000 × 45 days
= ₹4,50,000

Answer: Working Capital Requirement = ₹4,50,000

Interpretation: Company needs ₹4,50,000 to finance operations for 45-day cash cycle.

Method 2: Current Assets Holding Period Method

Problem 2: Calculate working capital requirement.

Given:

Estimated Annual Sales: ₹12,00,000
Cost of Goods Sold: 80% of sales
Average Inventory holding: 2 months
Average Receivables collection: 1 month
Average Payables payment: 1.5 months
Cash balance required: ₹50,000

Solution:

Step 1: Calculate monthly COGS

Annual COGS = 80% × ₹12,00,000 = ₹9,60,000
Monthly COGS = ₹9,60,000 / 12 = ₹80,000

Step 2: Calculate Inventory requirement

Inventory = Monthly COGS × Holding Period
= ₹80,000 × 2 months
= ₹1,60,000

Step 3: Calculate Receivables

Monthly Sales = ₹12,00,000 / 12 = ₹1,00,000
Receivables = Monthly Sales × Collection Period
= ₹1,00,000 × 1 month
= ₹1,00,000

Step 4: Calculate total Current Assets

Current Assets = Inventory + Receivables + Cash
= ₹1,60,000 + ₹1,00,000 + ₹50,000
= ₹3,10,000

Step 5: Calculate Payables (Current Liabilities)

Payables = Monthly COGS × Payment Period
= ₹80,000 × 1.5 months
= ₹1,20,000

Step 6: Calculate Net Working Capital

Net Working Capital = Current Assets - Current Liabilities
= ₹3,10,000 - ₹1,20,000
= ₹1,90,000

Answer: Net Working Capital Requirement = ₹1,90,000

5. Importance of Accurate Estimation

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Goal: Accurate estimation for optimal fund management.

Exam Pattern Questions and Answers

Question 1: "Calculate working capital using operating cycle method." (6 Marks)

Given:

Inventory period: 45 days
Receivables period: 30 days
Payables period: 40 days
Annual operating cost: ₹73,00,000

Solution:

Step 1: Operating Cycle

= 45 + 30 = 75 days

Step 2: Cash Cycle

= 75 - 40 = 35 days

Step 3: Daily Cost

= ₹73,00,000 / 365 = ₹20,000

Step 4: Working Capital

= ₹20,000 × 35 = ₹7,00,000

Answer: Working Capital = ₹7,00,000

Summary

Financial Requirements:

  • Fixed Capital: Long-term assets (land, machinery)
  • Working Capital: Short-term operations (inventory, receivables)

Estimation Methods:

  1. Operating Cycle Method: Daily cost × Cash cycle
  2. Current Assets Method: (Inventory + Receivables + Cash) - Payables

Key Formulas:

  • Operating Cycle = Inventory Period + Receivables Period
  • Cash Cycle = Operating Cycle - Payment Period
  • Working Capital = Current Assets - Current Liabilities
Exam Tip

For working capital problems: (1) Write Given, (2) State method/formula, (3) Show step-by-step: operating cycle → cash cycle → daily cost → WC requirement, (4) Write answer with units (₹). Show all intermediate steps!

Quiz Time! 🎯

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