When should I use the Turnover Method?

The Turnover Method is best suited for quick, high-level assessments and internal working capital management when detailed data is limited.

When is the CMA Method more appropriate?

The CMA Method is recommended for loan applications, detailed financial planning, and situations requiring a comprehensive and accurate working capital assessment.

What are the key limitations of the Turnover Method?

Its key limitations include the assumption of stable relationships between sales and working capital components and the neglect of seasonal fluctuations.

What factors should be considered when projecting sales in the CMA Method?

Factors such as market demand, pricing strategies, production capacity, and competitive landscape should all be considered.

Is it possible to combine both methods?

Yes, you can use the Turnover Method as a preliminary step to get a quick estimate and then refine the analysis using the CMA Method for a more detailed assessment.

Turnover Method vs CMA Method for Working Capital Assessment

Effective working capital management is essential for the smooth operation and financial stability of any business. Two widely used methods for assessing working capital requirements are the Turnover Method and the CMA (Credit Monitoring Arrangement) Method. While both aim to find out the optimal level of working capital, they differ a lot in their way and complexity. This post will provide a detailed comparison of these two methods, outlining their calculation steps, advantages, and disadvantages.

Understanding Working Capital

Working capital is the difference between a company's current assets and current liabilities. It represents the funds available for day-to-day operations. Efficient working capital management ensures that a company has sufficient liquidity to meet its short-term obligations without tying up excessive capital in unproductive assets.

The Turnover Method

The Turnover Method is a kind of simple method that relies on historical turnover ratios to estimate future working capital needs. It assumes a stable relationship between sales and different components of working capital.

Step-by-Step Tutorial: Turnover Method

Step 1: Calculate Turnover Ratios

So, First, calculate the turnover ratios for key working capital components using historical data. Common ratios include:

Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory
Debtors Turnover Ratio = Credit Sales / Average Debtors
Creditors Turnover Ratio = Credit Purchases / Average Creditors

Step 2: Convert Turnover Ratios to Conversion Periods

Convert the turnover ratios into conversion periods (e.g., number of days) using the following formulas:

Inventory Holding Period = 365 / Inventory Turnover Ratio
Debtors Collection Period = 365 / Debtors Turnover Ratio
Creditors Payment Period = 365 / Creditors Turnover Ratio

Step 3: Estimate Future Sales and Purchases

Project future sales and purchases based on anticipated growth rates or market trends.

Step 4: Calculate Estimated Working Capital Components

Use the conversion periods and projected sales/purchases to estimate the required levels of inventory, debtors, and creditors:

Estimated Inventory = (Cost of Goods Sold / 365) * Inventory Holding Period
Estimated Debtors = (Credit Sales / 365) * Debtors Collection Period
Estimated Creditors = (Credit Purchases / 365) * Creditors Payment Period

Step 5: Decide Working Capital Requirement

Calculate the total working capital requirement by summing the estimated current assets (inventory and debtors) and subtracting the estimated current liabilities (creditors):

Working Capital = Estimated Inventory + Estimated Debtors - Estimated Creditors

Advantages of the Turnover Method

Simplicity: Easy to understand and start using.
Data Availability: Relies on readily available historical data.
Quick Estimation: Provides a quick estimate of working capital needs.

Disadvantages of the Turnover Method

Assumes Stability: Assumes a stable relationship between sales and working capital components, which may not hold true in lively environments.
Ignores Seasonality: Does not account for seasonal fluctuations in sales or production.
Limited Accuracy: Provides a rough estimate rather than a precise calculation.

The CMA Method

In fact, The CMA (Credit Monitoring Arrangement) Method is a more detailed and thorough method used by banks and financial institutions to assess the working capital needs of borrowers. It involves a thorough analysis of the company's operating cycle, projected financials. Also, specific industry characteristics.

Step-by-Step Tutorial: CMA Method

Step 1: Project Sales and Cost of Goods Sold

Develop detailed projections of future sales and cost of goods sold, considering factors such as market demand, pricing strategies. Also, production capacity.

Step 2: Estimate Current Assets

Estimate the levels of inventory, debtors, and other current assets based on projected sales and industry norms. This often involves detailed analysis of inventory turnover, collection periods. Also, aging schedules.

Inventory: Look at raw materials, work-in-progress, and finished goods.
Debtors: Analyze credit terms, customer payment patterns, and bad debt provisions.
Other Current Assets: Include prepaid expenses, marketable securities, and other short-term assets.

Step 3: Estimate Current Liabilities

Estimate the levels of creditors, outstanding expenses, and other current liabilities based on projected purchases and payment terms. This requires careful consideration of supplier relationships and payment policies.

Creditors: Analyze payment terms, supplier relationships, and purchase patterns.
Outstanding Expenses: Include accrued salaries, utilities. Also, other short-term obligations.
Other Current Liabilities: Include short-term loans, overdrafts, and deferred revenue.

Step 4: Calculate Gross Working Capital

Calculate the gross working capital by summing all current assets:

Here's the thing: Gross Working Capital = Inventory + Debtors + Other Current Assets

Step 5: Calculate Net Working Capital

Calculate the net working capital by subtracting current liabilities from gross working capital:

Net Working Capital = Gross Working Capital - Creditors - Outstanding Expenses - Other Current Liabilities

Step 6: Find out Maximum Permissible Bank Finance (MPBF)

So, Banks often use a percentage of the net working capital to decide the maximum permissible bank finance (MPBF). Two common methods for calculating MPBF are:

Method I: MPBF = 75% of (Current Assets - Current Liabilities)
Method II: MPBF = Current Assets - (25% of Current Assets + Current Liabilities)

Advantages of the CMA Method

Thorough Analysis: Provides a more detailed and accurate assessment of working capital needs.
Industry Specific: Considers industry norms and specific business characteristics.
Used by Banks: Widely accepted by banks and financial institutions for loan assessments.

Disadvantages of the CMA Method

Complexity: More complex and time-consuming to put in place than the Turnover Method.
Data Requirements: Requires detailed financial projections and industry data.
Subjectivity: Involves some degree of subjectivity in estimating future sales and expenses.

Turnover Method vs. CMA Method: A Comparison Table

Feature	Turnover Method	CMA Method
Complexity	Simple	Complex
Data Requirements	Historical data	Projected financials, industry data
Accuracy	Less accurate	More accurate
Time Required	Quick	Time-consuming
Use Case	Quick estimates, internal assessments	Loan applications, detailed financial planning

Conclusion

In fact, Both the Turnover Method and the CMA Method have their own strengths and weaknesses. The Turnover Method is suitable for quick estimates and internal assessments, while the CMA Method provides a more complete and accurate analysis for loan applications and detailed financial planning. The choice of method depends on the specific needs and resources of the organization, as well as the purpose of the working capital assessment. Understanding the nuances of each method allows business professionals to make informed decisions regarding their working capital management strategies.