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.