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How to Calculate Working Capital using Sales Ratio Method?
What is Sales Ratio Method?
The sales ratio method is one of the easiest methods of calculating working capital. This method is based on the assumption that “history repeats itself.”
Therefore, to determine the working capital in this method, one has to have the past figures of sales in hand.
In the sales ratio method, the figure of working capital is determined as a percentage of sales, and the figure is obtained from the past performances of the company. This method is similar to technical analysis of the stock market where past performances of the stock are used to determine the future price and performance.
Working Capital Calculation Using Sales Ratio Method
The sales ratio method as mentioned above is a very simple and easy way to determine working capital.
If the sales and working capital figures of the previous year is in hand, the percentage of working capital out of sales is first determined. Now, this calculated percentage of working capital to sales is applied to the sales figure that is in hand for the present year.
For example, if sales were 200 million in the previous year and the working capital was 50 million, it means that the working capital to sales ratio is 25 percent. Now if the sales in the current year are 300 million, the working capital would be 75 million which is 25 percent of sales.
Some companies also calculate the sales ratio method for finding working capital according to the industry average. This is particularly helpful when past data on sales and working capital are unavailable.
For example, if the industry average of working capital is 25 percent of the sales figure, the working capital requirements for the present year of a company that has a sales figure of 60 million would be 12.5 million. It is as simple as that.
Advantage: Sales Ratio Method
The most notable advantage of the sales ratio method is that it is very easy to calculate. There are no complex calculations involved in determining the working capital if past data is in hand. As most of the companies have the past year’s data in hand, they do not feel any burden in calculating the working capital requirements for the present year.
Disadvantages: Sales Ratio Method
There are a few disadvantages associated with the process too.
Firstly, to determine the working capital needs in this process data from the previous years is taken. If there is no data available, the company cannot determine the working capital needs accurately for the present term.
This method of calculating working capital requirement is valid only when there is a linear relationship between working capital and sales. If the relationship between sales and working capital is not linear then the results of the method won’t be accurate.
Another disadvantage of this method is that it doesn’t consider fluctuations and cyclical plus seasonal variations into consideration while determining the working capital requirements. As most businesses go through changing seasonal sales and some companies have a cycle of the sales process, the method of determining the working capital via sales percentage figures is wrong.
Furthermore, the process is fully dependent on sales figures. If the sales figure is somehow wrong, the whole calculation of working capital will be wrong.
Wrong calculation of working capital is disrupting businesses as higher working capital attracts higher costs and lower profitability. Meanwhile, lower working capital impacts the smoothness of operations of a business company.
Conclusion
The sales ratio method for the estimation of working capital assumes that the working capital to sales ratio will remain constant and hence if the sales figure of the business can be analyzed, the working capital can be found as it will move in tandem with the sales figure.
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