An Example On How To Compute The Working Capital Requirements

In earlier articles, we learned about cash conversion cycle and other working capital management techniques.

Below is a simple illustration on how to compute the working capital requirement and a few suggestion to improve the computed amount:-

Let’s have say Division A in Company ABC Ltd plans to launch a new product. The plan is to ensure that the working capital requirement limit is not more than $180,000 imposed by Company ABC Ltd

Preliminary figures are prepared as below:

(a) The new product is planned to produce 20 units per week;

(b) Cost per unit as follows:

Direct material$400; Direct labor$200 & Overhead$225 -Total=825

(c) Two weeks are required for the production process

(d) The selling price per unit is $900

(e) The average stock holding level are planned as follows:
Direct material-5weeks & Finished goods-3weeks

(f) Credit terms are anticipated as follows:

Direct material-10weeks;Direct labor-1week;Overheads-6weeks & Debtors-10weeks

Required:

(i) Compute the amount of working capital that will be required.

(ii) Suggest two ways (supported with figures) that the amount of working capital required could be reduced.

Solution:

Compute the Working Capital Budget/Plan requirement:

Current Assets

Stocks-raw materials [W1] -$ 40,000

-Work-in-progress[W2] -$ 24,500

-Finished goods [ W3] -$ 49,500

Debtors [W4] -$180,000

Total Current Assets $294,000

Less:

Current Liabilities:

Creditors-materials [W5]-$80,000

Accruals-labor [W6]-$ 4,000

-overheads [W7]-$27,000

Total current liabilities $(111,000)

Gross working capital $183,000

Less: Profit $(15,000)

Net Working capital $168,000

Workings

[W1]-20 units x$400x5weeks=$40,000

[W2]- Materials-20unitsx$400x2weeks = $16,000

Labor -20unitsx$200x2weeksx50%= $4,000

Overheads-20unitsx$225x2weeksx50%= $4,500

Total $24,500

[ W3]-20 units x$825x3weeks=$49,500

[W4]-20 unitsx$900x10weeks=$180,000

[W5]-20 units x$400x10weeks=$80,000

[W6]-20 unitsx$200x1week=$4,000

[W7]-20 units x$225x6weeks=$27,000

[W8]-20units x($900-$825)x10weeks=$15,000

( ii) Two ways that the amount of working capital required could be reduced:

(a) Debtors credit period reduced to 8 weeks=20 x$900x8weeks=$144,000

(b) Creditors credit period reduced to 8 weeks=20 x$400x8weeks=$64,000

Therefore:

Reinstated current assets =$258,000

Less:current liabilities =$95,000

Gross working capital =$163,000

less:profit transferred =$(12,000)

(20unitsx$75x8weeks)

Net working capital =$151,000