Working Capital Calculation

Working Capital Calculation – What are the requirements?

In order to manage its cash flow a business needs to understand the working capital calculation.

Working capital is the amount of cash needed to fund the normal day to day trading operations of the business. In a simple business it would be calculated as inventory + accounts receivable – accounts payable which represents the funding needed to buy inventory and provide credit to customers, reduced by the amount of credit obtained from suppliers.

A well operated business needs to have an understanding of its working capital calculation and requirements so that it can quickly estimate what it’s cash needs will be. Working capital is a component of cash flow, and as such, as it increases the requirement for cash increases.

An Example of the Working Capital Calculation

As revenue is a readily available figure, the calculation will be based on this, enabling a business to quickly estimate its working capital requirements. The working capital calculation for each component is explained separately, but at the end these are merged to allow a simple rapid calculation to take place.

Accounts Receivable – working capital calculation

Suppose a business gives credit to it’s account customers of 60 days. At any point in time (ignoring sales tax) the accounts receivable can be estimated as 60/365 x revenue. So for example if the business had sales of 200,000, the working capital calculation shows that the funding required for accounts receivable is 60/365 x 200,000 = 32,900 (rounded). What this working capital calculation shows is that on average the business will need 32,900 in cash to fund the credit offered to account customers.

To allow for sale tax on the accounts receivable multiply by the rate. eg in the above example, if the sales tax was 20%, then the funding requirement would be 32,900 x 120% = 39,500.

Inventory – working capital calculation

Suppose the same business holds 60 days inventory. On average the sales value of the inventory held is going to be 60/365 x  revenue. However the cash invested in the inventory is the cost not the sales value. Assuming the business has a gross margin of say 60% (i.e. the cost is 40% of revenue), then the cost value of the inventory is approximately 40% x 60/365  x revenue = 40% x 60/365 x 200,000 = 13,200 (rounded). Again what the working capital calculation is showing is that the business will have an estimated 13,200 of cash tied up in its inventory.

Accounts Payable – working capital calculation

The working capital requirements of the business so far have both been cash outflows. Accounts payable represents credit supplied to the business by its suppliers, and as such helps to offset the cash outflow requirements. If the business takes credit from the suppliers then it does not have to pay them cash.

There are two main elements to accounts payable, the first is for inventory and the second is for overhead.

For inventory accounts payable, a similar calculation to that shown for inventory above is used. Suppose the business can get 30 days credit from suppliers. using a similar calculation as for inventory (as the business will buy at cost from the supplier not at sales prices), the working capital calculation shows that the funding provided by suppliers is  40% x 30/365 x revenue = 40% x 30/365 x 200,000 =  6,600 (rounded). So the working capital calculation shows that the amount of cash funding needed is reduced by 6,600 because of credit given by inventory suppliers.

For overhead accounts payable, an estimate has to be found based on the annual overhead in relation to revenue. By dividing annual overhead by the annual revenue the business can calculate that for example, overhead is currently 25% of revenue. If the business gets 30 days credit from suppliers then the working capital calculation would be 30/365 x 25% x revenue = 30/365 x 25% x 200,000 = 4,100 (rounded). So the working capital calculation shows that the amount of cash funding needed is reduced by 4,100 because of credit given by overhead suppliers.

Working Capital Calculation – putting it all together

In the above example we saw that the working capital requirement is as follows:

Working Capital Calculation:
Amount Calculation
Accounts receivable 32,900 60 / 365 x 200,000
Inventory 13,200 60 /365 x 40% x 200,000
Accounts payable – inventory -6,600 30 /365 x 40% x 200,000
Accounts payable – overhead -4,100 30 /365 x 25% x 200,000
Working capital requirement 35,400

In this particular example the working capital requirement is 35,400 which equals 35,400 / 200,000 = 17.7% of revenue. This figure of 17.7% now gives a simple calculation at any point in time to estimate working capital requirements.

Suppose the business anticipates an increase in monthly sales to 25,000, this is equivalent to 300,000 per year, and the working capital calculation shows that the requirement is 17.7% of 300,000 = 53,100, an increase of 53,100 – 35,400 = 17,700. This amount of cash will need to be provided by increased bank facilities or by changing the levels of inventory, accounts receivable, or accounts payable days to bring down the requirement to previous levels.

General Formula for the Working Capital Calculation

To generalize this calculation we can write the working capital calculation as follows:

Working capital requirement = Revenue x (Accounts receivable days / 365 +
Cost of sales% x inventory days / 365 –
Cost of sales% x accounts payable days for inventory / 365 –
Overhead % x accounts payable days for overhead / 365)

In the example above the formula would be used at the start of the year to give:
Working capital requirement = Revenue x (60 / 365 + 40% x 60 / 365 – 40% x 30 / 365 – 25% x 30 / 365) x 100% = Revenue x 17.7%

You only need to do this calculation periodically (depending on how rapidly your business is changing) to give the percentage to apply to your current revenue levels. In a stable business the percentage tends not to change a great deal.

Working Capital Calculator Download

A working capital calculator is available for download in Excel format by following the link below.
Working Capital Calculator Spreadsheet Download Link

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Working Capital Calculation November 6th, 2016Team

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