Don’t just guess how much working capital your FDI business needs to maintain daily operations. You need a precise formula and a clear result so that you can create a concrete plan. Otherwise, your business may face issues such as working capital shortages or excess capital leading to wasted resources. Let’s explore with KMC how to calculate working capital requirements in the following article:
What is Working Capital?
Working capital is an essential resource that enables businesses to cover short-term expenses such as payments to suppliers, employee salaries, taxes, and other operating costs. It includes cash, inventory, and accounts receivable (money owed by customers).
For FDI enterprises, working capital is particularly important. It ensures that production and business operations can run continuously while also building trust with international partners through timely payments.
Formula for Calculating Working Capital Requirements
Formula:
Working Capital Requirement = Current Assets – Current Liabilities
Detailed Explanation:
Current assets are the “available resources” that a business can use within 12 months or one business cycle. They include:
- Cash and bank deposits
- Accounts receivable from customers
- Inventory awaiting sale
- Short-term financial investments
Current liabilities are obligations that a business must settle within one year. Examples include:
- Payments to suppliers
- Salaries payable to employees
- Taxes payable to the state budget
- Short-term loans from banks or financial institutions
Practical Example:
If you have VND 500 million in cash, VND 200 million in accounts receivable from customers, and VND 300 million in inventory, then your total current assets amount to VND 1,000 million (VND 1 billion). If current liabilities are VND 600 million (including payments to suppliers and bank loans), your working capital requirement will be:
VND 1,000 million – VND 600 million = VND 400 million.
This figure shows that you still have VND 400 million available to maintain operations or make additional investments.
Detailed Calculation of Working Capital Requirements Based on the Cash Conversion Cycle (CCC)
Step 1: Understand the Cash Conversion Cycle (CCC)
The cash conversion cycle reflects the average number of days from when a business spends money (purchasing raw materials, production) until it collects cash from customers. The formula for CCC is:
CCC = DIO + DSO – DPO
Where:
- DIO (Days Inventory Outstanding): The average number of days it takes to sell out inventory.
- DSO (Days Sales Outstanding): The average number of days it takes to collect payment from customers.
- DPO (Days Payable Outstanding): The average number of days it takes to pay suppliers.
A shorter cash conversion cycle means the business can recover capital faster, thereby reducing working capital requirements.
Step 2: Calculate Each Component of the CCC
To calculate CCC, you need financial data from company reports. Below are the calculation methods:
Calculate DIO (Days Inventory Outstanding)
Formula:
DIO = (Average Inventory / Cost of Goods Sold) × 365
- Average Inventory = (Beginning Inventory + Ending Inventory) / 2
- Cost of Goods Sold (COGS): The total cost of producing goods sold during the period (taken from the income statement).
Example: If average inventory is VND 500 million and COGS is VND 3.65 billion:
DIO = (500,000,000 / 3,650,000,000) × 365 = 50 days.
Calculate DSO (Days Sales Outstanding)
Formula:
DSO = (Average Accounts Receivable / Net Sales) × 365
- Average Accounts Receivable = (Beginning A/R + Ending A/R) / 2
- Net Sales: Total sales revenue after deductions, taken from the income statement.
Example: If average accounts receivable is VND 300 million and net sales are VND 5 billion:
DSO = (300,000,000 / 5,000,000,000) × 365 = 22 days.
Calculate DPO (Days Payable Outstanding)
Formula:
DPO = (Average Accounts Payable / Cost of Goods Sold) × 365
- Average Accounts Payable = (Beginning A/P + Ending A/P) / 2
- Cost of Goods Sold: as defined above.
Example: If average accounts payable is VND 400 million and COGS is VND 3.65 billion:
DPO = (400,000,000 / 3,650,000,000) × 365 = 40 days
Calculate CCC
Once you have DIO, DSO, and DPO, apply the formula:
CCC = DIO + DSO – DPO
Example: If DIO = 50, DSO = 22 days, and DPO = 40 days, then:
CCC = 50 + 22 – 40 = 32 days.
This means the business needs 32 days to convert input costs into cash.
Step 3: Calculate Working Capital Requirements
Working capital requirements are calculated based on the daily operating costs needed to maintain operations throughout the cash conversion cycle.
Formula:
Working Capital Requirement = Daily Operating Expenses × CCC
- Determine daily operating expenses:
Take the total annual operating expenses (including cost of goods sold, operating costs, personnel expenses, etc.) and divide by 365 days.
Example: If total annual operating expenses are VND 7.3 billion:
Daily operating expenses = 7,300,000,000 / 365 = VND 20 million/day.
- Calculate working capital requirement:
Working Capital Requirement = 20,000,000 × 32 = VND 640 million.
This means the business needs approximately VND 640 million to maintain operations throughout the cash conversion cycle.
Important Notes:
- FDI enterprises in heavy industries such as mechanics and construction often have a longer CCC compared to those in retail or services. Therefore, you need to adjust your working capital management strategy according to the characteristics of your industry.
- Working capital requirements are not fixed, so you should update them periodically based on market fluctuations, credit policies, or changes in the supply chain.
- To reduce working capital requirements, consider applying inventory strategies, accelerating receivables collection, or negotiating longer payment terms with suppliers.
Now that you know how to calculate working capital requirements, it’s time to put it into practice. If you not only want accurate calculations but also aim to build an effective financial management system, use KMC’s services. We will help you analyze and forecast cash flow, advise on an optimal working capital structure, and develop receivables/payables management policies. Contact KMC now for a free consultation.
