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What is Current Assets Holding Period Method?
Current Assets Holding Period Method
The current assets holding period method is used to estimate the working capital needs of an organization based on the current assets the company holds. To estimate the working capital needs, the average holding period of the current assets is related to costs based on the firm’s experience in the last year. This method is essentially an operating cycle method.
There are a host of factors that affect the working capital calculations. Factors that are most influential include
- Seasonal fluctuations
- Investment costs
- Accurate sales forecasts
- Variability in sales price
- Credit policies
- Production cycle
- Collection policies.
Operating or Working Capital Cycle
The operating cycle of a product is the number of days the prices of the raw materials are paid, it enters into stock, goes through work in process, and ultimately sales of finished goods are obtained. To get the operating cycle, the days in each stage can be added.
The operating cycle can be used to calculate the working capital of a company. For doing so, accounts receivable, inventory, and accounts payable terms must be considered.
Accounts receivables show the average number of days it takes to collect an account.
The inventory shows the number of days the product comes to the store to the day it is sold and cash is generated.
Accounts payable is the average number of days it takes to pay the suppliers.
Most companies cannot finance the operating cycles with accounts payable finances alone. Therefore, working capital financing is needed. If there is any shortfall, it must be filled by the profits generated and kept internally or through borrowed finances, or by a combination of the two.
Growing companies need more working capital or current assets as they expand fast. The best form of working capital is retained earnings. Good management of working capital generates cash that can be used to grow and mitigate the risks. Moreover, the cash generated also helps the company manage to hold current assets for enough long time.
Each of the components of working capital has two dimensions attached to it. These dimensions are time and money. When the subject is to manage the working capital, then time acts as money. If the money can be rotated around faster or when the amount of money tied up is reduced, the business will generate more cash or it will need less money to fund working capital.
The determination of the working capital cycle or current asset holding period helps forecast, control, and management of working capital. The net operating cycle represents the interval of time a company asks for working capital from its bankers. It helps in the determination of the accurate working capital amount to run a business continually.
In terms of an equation, the operating cycle process can be expressed as
R = Raw materials storage period
W = Work in progress holding period
F=Finished goods storage period
D= Debtors collection period
C= Credit period allowed by suppliers
If a company can manage more days to pay for its raw materials to suppliers, it can generate free finance to help fund future sales.
Lastly, considering the theory of time and money, some relationships that are found while discussing this tutorial include −
When receivables (debtors) are collected faster, then funds can be released from the cycle.
When receivables are collected slower, then receivables soak up cost.
When a better and more elongated credit policy is obtained from the suppliers, then the cash resources are increased.
When inventories are shifted faster, cash is freed up.
When inventories are shifted slower, more cash is consumed.
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