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What is meant by Fixed Investment Ratio Method?
Fixed Investment Ratio Method
Every business needs to maintain an optimum level of working capital to run the business smoothly. While excessive working capital harms the business inadequate amount of working capital is also a matter of concern. Therefore, businesses must estimate the working capital needs for the shorter and longer-term efficiently.
The fixed investment ratio method for the calculation of working capital is a popular method. The fixed investment ratio method is one such method that can be adopted to determine the working capital needs of a company.
Working Capital Calculation as A Percentage of Fixed Assets
The calculation of working capital a trade-off between Long-term and Short-term Financing s a percentage of fixed assets is based on the fact that every business has total assets that comprise total fixed assets and total current assets.
Depending on past performance and experience, a relationship between total current assets or gross working capital; or net working capital that is current assets - current liabilities can be established.
For example, if a company is managing its business with 25% of current assets and the total assets are Rs 40,00,000 next year, the total amount of current assets would be Rs 10,00,000.
The working capital requirements can be calculated in the same manner. In fact, firms plan future levels of fixed assets regarding capital budgeting decisions. To service the fixed assets, a firm must maintain a good balance of working capital. Therefore, the working capital requirements are related to the fixed assets of a company.
The estimation of working capital, therefore, depends on the estimation of fixed assets (capital) which depends on capital budgeting decisions. It must be noted here that the investment decisions of a company are related to capital budgeting decisions which are linked with fixed assets. It is also related to working capital management which is linked with current assets and current liabilities. Therefore, the estimation of working capital that is part of the investment decision must be made along with capital budgeting decisions.
Disadvantages: Fixed Investment Ratio Method
Fixed Investment Ratio Method has some notable advantages, such as easiness of calculation and readily available data on which the calculation can be made. However, there are some stark disadvantages related to this model that make it a weaker choice.
The fixed investment ratio method seems quite easy to calculate but in fact, it is a tough task. As the calculation requires the calculation of current assets in regard to fixed assets, it becomes quite difficult to estimate the working capital requirements. As the determination of current assets that are invested as the fixed investment is cumbersome, finding the working capital requirements via fixed assets turns complex as well.
Another disadvantage of this method is that the value of the fixed assets must be known to carry out the overall calculation of working capital requirements. When the data of fixed assets is unavailable the working capital requirement calculations cannot be carried out. Moreover, if the figure for fixed assets is faulty, the overall result of working capital requirement would also be faulty.
The fixed investment ratio method is calculated in percentage terms of the fixed assets which can lead to erroneous outcomes when the fixed assets are influenced by seasonal or cyclical fluctuations.
Every business process goes through seasonal upsides and downsides and when such details are unavailable or ignored, the real estimation of working capital requirements gets affected. Thus, it is hard to avoid errors in the calculation of working capital requirements when the fixed investment ratio is utilized.
Conclusion
The unavailability of dependable data and errors that creep in during the calculation of working capital makes the fixed investment ratio method a bit disadvantageous in nature at times.
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