Working capital is needed by all businesses to fund the necessary investment in inventory and accounts receivable to allow normal day to day trading to continue. The higher the working capital requirements, the greater the amount of funding the business requires.
Working Capital Requirements Formula
The working capital equation can be written as follows:
While this formula applies to any business, for a manufacturer inventory is more complicated and is made up of three components:
- Raw materials
- Work in process (WIP)
- Finished goods
The manufacturer has to purchase and hold an inventory of raw materials, issue the materials into work in process (WIP) and apply direct labor and overhead to convert the raw materials into finished goods.
The working capital requirements equation can be adapted for a manufacturer can be written as follows:
Forecasting Working Capital Requirements Example
At any point in time a manufacturing business needs to be able to estimate its working capital requirements. As the revenue figures are normally available or first to be included in the financial projections, the simplest way to do this is to calculate the working capital requirements as a percentage of revenue.
Suppose a manufacturing business has a revenue of 300,000, and operates at a gross margin percentage of 45%.
Suppose the business holds 60 days raw materials inventory. As raw materials are purchased direct from suppliers, the calculation should be based on the average daily purchases. If this is not available then providing inventory levels remain fairly constant, an estimate can be obtained based on the raw material content of the cost of sales.
The cost of sales can be found using the following formula:
Assume the manufacturing gross product margin calculation shows that raw material content of the product is estimated to be 15% of the total cost, then daily purchases can be estimated as follows:
Purchases = 15% x Cost of sales Purchases = 15% x 300,000 x (1-45%) Purchases = 24,750 Daily purchases = 24,750 / 365 = 67.81
Obviously, if an actual figure for daily purchases is known then that figure should be used, however in the absence of this, using our estimated figure value for daily purchases, the raw materials can now be estimated as follows:
Raw materials inventory = Days raw materials inventory x Daily purchases Raw materials inventory = 60 x 67.81 Raw materials inventory = 4,068 Raw materials inventory % = 4,068 / 300,000 = 1.4%
The raw materials inventory working capital requirements is 4,068 or 1.4% of revenue.
Work in Process
A similar calculation can be carried out to find the working capital requirement for work in process. Suppose in our example we assume the business on average takes 40 days to manufacturer its products and therefore holds 40 days work in process. Using this information we can estimate the WIP working capital requirement based on the cost of sales as follows:
WIP = Days WIP x Daily cost of sales WIP = Days WIP x Daily revenue x (1 - Gross margin %) WIP = 40 x (300,000 / 365) x (1 - 45%) WIP = 18,082 WIP % = 18,082 / 300,000 = 6.0%
The WIP inventory working capital requirement is 18,082 or 6.0% of revenue.
Likewise a calculation can be carried out to find the working capital requirement for finished goods inventory.
Suppose the business holds 30 days finished goods inventory, then the level of inventory can be calculated as follows:
Finished goods = Days Finished goods x Daily cost of sales Finished goods = Days Finished goods x Daily revenue x (1 - Gross margin %) Finished goods = 30 x (300,000 / 365) x (1 - 45%) Finished goods = 13,562 Finished goods % = 13,562 / 300,000 = 4.5%
The finished goods inventory working capital requirement is 13,562 or 4.5% of revenue.
Combining these three calculations the total inventory working capital requirement is 11.9% (1.4% + 6.0% + 4.5%) of revenue.
Accounts Receivable and Accounts Payable
As with any business, the manufacturing business will also have an additional requirements necessary to fund credit given to customers (accounts receivable), offset by funding provided by suppliers (accounts payable). (This is more fully explained in our post on How to Calculate Working Capital Requirement.
For the sake of completeness, suppose the terms offered to customers are 45 days and the terms received from suppliers are 20 days, then the working capital requirements are calculated as follows:
For accounts receivable:
Accounts receivable = Days credit x Daily revenue Accounts receivable = 45 x 300,000 / 365 Accounts receivable = 36,986 Accounts receivable % = 36,986 / 300,000 = 12.3%
For accounts payable:
Accounts payable = Days credit x Daily cost of sales Accounts payable = Days credit x Daily revenue x (1 - Gross margin %) Accounts payable = 20 x (300,000 / 365) x (1 - 45%) Accounts payable = 9,041 Accounts payable % = 9,041 / 300,000 = 3.0%
Net Working Capital Requirements
We can now combine the accounts receivable, inventory, and accounts payable working capital requirements to give the net working capital requirements for the manufacturing business.
This is summarized for our example, in the table below:
|Work in process||40||18,082||6.0%|
|Gross working capital requirements||72,699||24.2%|
|Net working capital requirements||63,658||21.2%|
Based on this information, the net working capital requirements is 21.2% of revenue. Although this figure will change overtime, providing the business is relatively stable, it gives a good indicator of what the potential working capital requirements is for the manufacturing business.
Suppose for example, the business is offered a new contract worth 75,000 in revenue, it can now estimate that if the contact is accepted, it will most likely need an additional 75,000 x 21.2% = 15,900 of funding to deal with the increased business as summarized below.
|Work in process||6.0%||4,500|
|Gross working capital requirements||24.2%||18,150|
|Net working capital requirements||21.2%||15,900|
Working Capital in the Financial Projections Template
The financial projections template uses these calculations based on revenue, cost of sales and days to work out the accounts receivable, inventory, and accounts payable shown in the balance sheet, this in turn leads to the change in working capital shown in the cash flow statement of the business.
By amending the inventory days, days sales outstanding, and days payable outstanding, it is possible to change the working capital requirements of the business and see the impact of this on the cash flow statement.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Plan Projections. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a BSc from Loughborough University.