Estimating working capital needs is critical when starting up a new business, and when going through a period of growth and expansion.  By understanding the cycles a business goes through, and assigning some numbers to them, it is possible to come up with a realistic estimate of how much working capital you should have on hand.  And, when a business is experiencing financial difficulties, an analysis of these cycles and the impact they have on cash flow and resources enables taking the necessary steps to turn the situation around.

Working Capital Cycle and Cash Conversion Cycle

A production environment, whether large or small, may serve as a good example for defining the different stages a business operation goes through, from the time commitments are made for raw materials, supplies, and services, until payment is received from the customer for the final product sold. 

Working capital includes inventory, payables, and receivables, so the working capital cycle covers the period from when commitments are first made until payment is received from the customer.  The working capital cycle may differ from the cash conversion cycle, since goods and services may be purchased on credit; certain expenses such as salaries, wages, and utilities accrue during the period; and sales to the customer may be on credit terms.  So, the cash conversion cycle is the time from payment of accruals to collection of receivables.  It is the amount of time cash is tied up in the cycle, and not available for other purposes.

Throughout the process, incremental costs will continue to be added and will need to be financed with working capital until payment is received and the cycle is complete. For example, at the start of the production period the costs are in raw materials.  As production begins, costs for labor, supplies, and overhead are added.  When finished goods are placed in inventory, storage costs may be incurred.  And the sale of the products to customers may involve shipping costs, commissions, or other selling expenses.  Working capital requirements increase as the business cycle progresses.

Ongoing Cycles

Another point to take into consideration is that cycles are ongoing.  Purchases and collections may be made every day during the period, so the cycle for one particular product overlaps with the cycle for another product.  The cycle is constantly repeating itself, and at any given point in time, each individual cycle will be at a different stage of completion.  The idea is to come up with a way to determine average balances for inventory, payables and receivables in order to determine an overall estimate of working capital needs.

Breaking Down the Cycle

The entire process starts with the receipt of raw materials.  If they are purchased on credit, there is a commitment, in terms of accounts payable, but a cash disbursement has not yet been made.  So in effect, the time from when a purchase commitment is made until the time the supplier is paid is really financing that the business is gaining, and serves to reduce the need for other sources of financing.

If production is not started immediately, there will be a period of time when raw materials are in inventory.  Once production starts, the raw materials will enter the next phase - the work-in-process inventory, where additional costs such as labor and utilities will be added.  The work-in process period ends when the products are completed and the production cycle ends with the finished goods inventory.

It may turn out that products are not sold immediately upon completion, so there is a period when finished products remain in inventory pending their sale.  And when sales are made, there may be a delivery period involved, and the sales may be on credit terms, so the process enters the final period in which accounts receivable are pending payment.  Once collection is made and payment is received from the customer, the cycle is complete.

So, the overall business cycle can be broken down as follows:

• Number of days raw materials are in inventory
• Minus number of days of accounts payable to suppliers
• Plus number of days in work-in-process
• Plus number of days products are in finished goods inventory
• Plus collection period from customers
• Equals cash conversion period.

Once these periods are defined, calculations can be made to begin to develop an estimate of working capital needs.

Calculating Periods

In order to calculate the number of days involved in each part of the process, some estimates may have to be made.  The date may be available and it may need to be updated occasionally, in order to obtain a more realistic result.  Or it may simply need to be estimated.  The following formulas will indicate the figures that are needed.

The average number of days raw materials are in inventory can be calculated as:

• Average raw materials inventory / Average annual purchases x 365 = Days of raw materials inventory

Average days in work-in-process are calculated as:

• Average balance of work-in-process inventory / Average annual cost of production x 365 = Days of work-in-process inventory

Average days of finished goods inventory are:

• Average balance of finished goods inventory / Average annual cost of sales x 365 = Days of finished goods inventory

Terms with Suppliers and Customers

The other periods involved in the cycle are the average payment terms with suppliers for purchases of materials, the average payment period for other expenses, and the average credit terms with customers for sales.  With this information, the first stage of calculating working capital needs based on days of sales to finance is complete.  The next stage involves assigning values to these periods.

Number of Days

Based on the above calculations, an example could be generated, as follows:

• Days of raw materials inventory = 5
• Days of work-in-process inventory = 15
• Days of finished goods inventory = 10
• Payment terms with suppliers = 30
• Payment terms for other expenses = 10
• Credit terms with customers = 45

This information may be available from historical records on production, or based on personal experience in the business.  Or it may be based on contractual terms, such as payment terms with suppliers and credit terms with customers.

Percentage Components of Sales Price

The next step is to express the final sales price of the product in terms of its component parts; that is, what part of the sales price is represented by raw materials and other expenses.  If it is assumed for purposes of this example that raw materials represent 20% of the final sales price and other expenses represent 50%, these percentages can then be applied to the number of days involved in each stage of the cycle, as previously determined, to calculate the number of days of sales that need to be financed.  For purposes of the example, it is assumed that work-in-process contains both the 20% component for raw materials and the 50% component for other expenses.  In practice, the costs invested in work-in-process depend on the stage of completion of the products in inventory.  It may be necessary to refine this aspect, based on the particular business and the level of information available.

Calculating Days Based on Percentage Components

Based on the foregoing information, the number of days involved in each separate period of the process times their corresponding percentage component of the sale price are as follows:

• Raw materials: 5 days x 20% = 1 day
• Work-in-process: 15 days x 70% = 10.5 days
• Finished goods: 10 days x 70% = 7 days
• Suppliers: 30 days x 20% = 6 days (this number is subtracted)
• Other expenses:  10 days x 50% =  5 days
• Customers: 45 days x 70% = 31.5 days
• Equals total number of days of sales to finance:  49 days

Calculating Days of Sales to Finance

The next step is to take the total estimated annual sales and express them in terms of sales per day.  For example:

Total annual sales of $500,000 / 365 days = $1,370 per day

The number of days of sales to finance (49 days) times sales of $1,370 per day equals an estimated working capital requirement of $67,130.

The above example outlines the general steps involved in estimating working capital requirements using this methodology, and by refining the date a closer approximation can be obtained.