Estimation of Working Capital - Other Methods

Prerequisites

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1. Sales Method (Percentage of Sales Method)

This is a simple, quick estimation technique based on the relationship between sales and working capital.

1.1 Basic Principle

The method assumes that working capital requirements vary proportionally with sales. If sales double, working capital requirement will also double.

Formula:

1.2 Steps to Estimate

Step 1: Find the historical relationship (ratio) between Working Capital and Sales.

WC/Sales Ratio = Past Year's WC / Past Year's Sales

Step 2: Apply this ratio to estimated future sales.

Estimated WC = Estimated Sales × WC/Sales Ratio

1.3 Numerical Problem (Exam Format)

Problem: XYZ Ltd. had sales of ₹50,00,000 last year with working capital of ₹10,00,000. For the next year, sales are estimated at ₹60,00,000. Estimate the working capital requirement.

Given:

Last Year's Sales = ₹50,00,000
Last Year's Working Capital = ₹10,00,000
Estimated Sales (Next Year) = ₹60,00,000

Solution:

Step 1: Calculate WC/Sales Ratio

WC/Sales Ratio = ₹10,00,000 / ₹50,00,000
                = 0.20 or 20%

Step 2: Apply ratio to estimated sales

Estimated WC = Estimated Sales × WC/Sales Ratio
             = ₹60,00,000 × 0.20
             = ₹12,00,000

Answer: The estimated working capital requirement for next year is ₹12,00,000.

Interpretation: Since sales are increasing by 20% (from ₹50L to ₹60L), working capital also increases by 20% (from ₹10L to ₹12L).

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2. Advantages and Limitations of Sales Method

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3. Regression Analysis Method

This is a statistical/mathematical method that uses regression techniques to establish the relationship between working capital and one or more independent variables (usually sales).

3.1 Simple Linear Regression

The most common form establishes a linear relationship:

Formula:

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3.2 How to Find 'a' and 'b'

Using the Least Squares Method:

b = [n(ΣXY) - (ΣX)(ΣY)] / [n(ΣX²) - (ΣX)²]

a = (ΣY/n) - b(ΣX/n)

or

a = Ȳ - bX̄

Where:
- X = Sales
- Y = Working Capital
- n = Number of observations
- X̄ = Average of X
- Ȳ = Average of Y

3.3 Numerical Problem (Simplified for B.Com)

Problem: The following data is available for ABC Ltd. for the last 4 years. Estimate the working capital requirement for Year 5 when sales are expected to be ₹70 lakhs.

Year	Sales (₹ Lakhs) X	Working Capital (₹ Lakhs) Y
1	40	8
2	50	10
3	60	12
4	65	13

Solution:

Step 1: Prepare calculation table

Year	X (Sales)	Y (WC)	XY	X²
1	40	8	320	1,600
2	50	10	500	2,500
3	60	12	720	3,600
4	65	13	845	4,225
Σ	215	43	2,385	11,925

Step 2: Calculate 'b' (slope)

n = 4
b = [n(ΣXY) - (ΣX)(ΣY)] / [n(ΣX²) - (ΣX)²]
b = [4(2,385) - (215)(43)] / [4(11,925) - (215)²]
b = [9,540 - 9,245] / [47,700 - 46,225]
b = 295 / 1,475
b = 0.20

Step 3: Calculate 'a' (intercept)

X̄ = ΣX/n = 215/4 = 53.75
Ȳ = ΣY/n = 43/4 = 10.75

a = Ȳ - bX̄
a = 10.75 - (0.20 × 53.75)
a = 10.75 - 10.75
a = 0

Step 4: Form regression equation

WC = a + b(Sales)
WC = 0 + 0.20(Sales)
WC = 0.20 × Sales

Step 5: Estimate WC for Year 5

Sales (Year 5) = ₹70 lakhs
WC = 0.20 × 70
WC = ₹14 lakhs

Answer: The estimated working capital requirement for Year 5 is ₹14 lakhs (when sales are ₹70 lakhs).

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4. Advantages and Limitations of Regression Method

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5. Comparison of All Three Methods

Method	Accuracy	Complexity	Data Needed	Best For
Sales Method	Low	Very Simple	Minimal (1-2 years)	Quick estimates, stable businesses
Regression Method	Medium	Moderate	Historical data (3-5 years)	Mid-term planning, trend analysis
Operating Cycle Method	High	Complex	Detailed operational data	Detailed planning, new ventures

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Exam Pattern Questions and Answers

Question 1: "Explain the Sales Method of estimating working capital with an example." (4 Marks)

Answer: The Sales Method, also known as Percentage of Sales Method, estimates working capital requirement based on the historical relationship between sales and working capital. It assumes that WC varies proportionately with sales.

Formula: WC Required = (Past WC/Past Sales) × Estimated Sales

Example: If last year's sales were ₹40,00,000 with WC of ₹8,00,000 (20% ratio), and next year's estimated sales are ₹50,00,000, then: Estimated WC = ₹50,00,000 × 20% = ₹10,00,000

This method is simple but ignores operational improvements and changes in business conditions.

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Question 2: "Why is the Operating Cycle Method considered more accurate than the Sales Method?" (4 Marks)

Answer: The Operating Cycle Method is more accurate because:

1. Component-wise Analysis: It separately calculates requirements for each component (RM, WIP, FG, Debtors) based on actual holding periods, whereas Sales Method uses a blanket ratio.
2. Time Factor: It considers the actual time duration for which funds remain locked in different stages of operations, providing a realistic estimate.
3. Operational Changes: It can easily accommodate changes in credit policy, inventory turnover, or production efficiency by adjusting the respective periods.
4. Flexibility: It can be adapted to seasonal variations and business cycle changes, while Sales Method assumes a fixed relationship with sales.

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Summary

Three Methods for WC Estimation:

1. Sales Method: WC = Sales × Ratio (Quick but approximate)
2. Regression Method: WC = a + b(Sales) (Statistical, medium complexity)
3. Operating Cycle Method: Component-wise calculation (Most accurate)

Choice of Method depends on:

• Purpose (rough estimate vs. detailed planning)
• Data availability
• Time available for analysis
• Stage of business (new vs. established)

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Quiz Time! 🎯

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