Project Appraisal

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Calculation of working capital for the evaluation of

projects in developing countries

Axel Sell

To cite this article: Axel Sell (1989) Calculation of working capital for the evaluation of projects in
developing countries, Project Appraisal, 4:3, 151-156, DOI: 10.1080/02688867.1989.9726725

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Project Appraisal, volume 4, number 3, September 1989, pages 151-156, Besch Troe Publishing, 10 Witford
Financial analysis
Calculation of working capital for
the evaluation of projects in
developing countries
Axel Sell
The main differences between some approaches
for calculating the different items of working
capital of a project are discussed. On the basis of
an analysis of the working capital in the context of
a cash flow analysis as the core of financial ap-
praisal of projects, suggestions are developed for
which periodical cost or sales flgures should be
used as a basis for the estimation.
Keywords: working capital; developing countries; project appraisal
Professor Axel Sell is in the Fachbereich7 (Economic Department),
Institute for World Economics and International Management.
Universitat Bremen, Postfach 330 440, D-2800 Bremen 33, F R
Germany.
Project Appraisal September 1989 0268-8867/89/030151-6US$OS.OO @Beech Tree Publishing 1989
Close, Guildford. S u m y , GUI 2EP, England.
T
HE GUIDELINES FOR project evaluation of
international development organizations, fi-
nance agencies and also some national planning
boards in developing countries stress the importance of
a proper treatment'of working capital in project plan-
ning and evaluation. Ignoring the requirements of
working capital could result in liquidity problems and
would lead to an overestimation of the profitability of
projects (Asian Development Bank, 1983, pages
121 ff). Working capital in most industries is higher
than fixed investment, and even net working capital as
a rule amounts to between one quarter and one third of
the total balance sheet (Sell, 1989, pages 365 ff).
Most of the guidelines suggest specific procedures
for the calculation of the different items of working
capital and some also offer some formalized tables as a
tool for practical application (DuvigneauPrasad, 1984;
State Planning Commission of China, 1987; UNIDO,
1978; Sell, 1989). The different items are usually
calculated directly or indirectly as a percentage of
revenues or the particular cost figures of a period. The
purpose for this paper is to shed light on some differ-
ences in these approaches.
First we will deal wilh working capital and net
working capital in the context of the balance sheet. In
most text-books this is the starting point for explaining
thc need for a proper handling of working capital in the
planning process.
Next we will discuss working capital in the context of
thc cash flow analysis as the starting point for liquidity
planning and as the basis for the applicationof dynamic
investment criteria. The different suggestions in litera-
ture dealing with the calculation of the different items of
working capital will then be confronted with the re-
quirements of a logical cash flow analysis as the core of
financial appraisal of projects.
151
Working capital in project evaluation

Balance sheet therefore, some products are not finished, however,

Working capital
The main reasons for firms to invest in current assets or
working capital are:
0 To avoid potentially high costs of adjusting to uncer-
tain events (such as an interruption in the supply of
raw materials inputs);
0 To stimulate sales by crediting customers. By cred-
iting customers at every point of time the firm is in
possession of receivables (Archer et al, 1983, pages
601 ff).
There are some other reasons too, that, in part, are not
controlled by the firm.
The following list of items provides a more detailed
breakdown of working capital:
they have absorbed some inputs.
0 Receivables: It is customary to credit some sales in
most industries.
0 Cash in hand: Some cash is necessary for uncertain
events.
Advance payments for purchases are required for
some inputs (for instance from the construction in-
dustry).
Current liabilities and advance receipts
Raw materials, utilities and some other inputs are usu-
ally purchased on credit and will thus reduce the capital
needed from other sources to run the project. This also
holds for advance receipts from sales common in some
industries.
Net working capital

Raw materials inventories: These assets are neces-
sary to avoid costs of adjustment due to uncertainty
about the production level and possible intemptions
in the supply of materials.
Spare parts: Some inventories are necessary to avoid
interruptions of the production process because of
defective parts. This argument holds especially for
imported spare parts that are not easily available in
the local market.
Finished goods: Some stock is necessary to serve a
sudden increase in demand. Moreovcr, it is some-
times unavoidable because of an unexpected de-
crease in demand. Hence the stock of finished goods
could also be looked upon as a buffer stock to avoid
sudden changes in the utilization rate of the capacity
which normally would result in higher total produc-
tion costs per unit.
0 Work in progress: A product has to pass through
different stages of processing. At every point of time
Assets Liabilities
Pre-production costs
Fixed investment
- land and site preparation
- building and civil
engineering
- plant, machinery
- industrial property rights etc Permanent
capital
~~~~~ ~
Net working capital is usually defined as the difference
between current assets and current liabilities including
advance receipts from sales. It thus represents those
parts of the current assets that have to be financed by
equity capital, bank loans and other financial means. As
fixed investment, pre-production costs and net working
capital have to be financed permanently by the project,
according to certain financial rules, they should be
financed by permanent capital (equity capital and/or
long-term loans). In the balance sheet the net working
capital can be identified as shown in Figure 1 (see for
instance UNIDO,1978, page 157).
Cash flow analysis
The discussion of net working capital in the context of
the balance sheet is a didactic help to demonstrate that
there is an additional need for financial means besides
the financeof fixed assets. The stocksof inventoriesand
liabilities are shown for a fixed day and are assumed to
represent the average stocks during the period,
Liquidity planning and financial analysis, however,
are based on cash flow figures and not on balance sheet
items. Hence, in order to determine the correct numbers
for specific items of working capital it is more useful to
discuss these aspects in cash flow figures.
We have to distinguish between expenditures and
costs on the one hand, and incomes and revenues on the

other. Expenditures represent an outflow of cash within

Current assets: a given period, whereas costs represent the value of
- production materials
I

- spareparts working
- work in progress
- finishedgoods capital
Liquidity planning and financial
- cashin hand
..... analysis are based on cash flow figures,
...
Current
not balance sheet items: so to
liabilities determine working capital it is more
useful to discuss cash flow
Figure 1: Worklng and net worklng capital in the balance sheet

152 Project Appraisal September 1989


inputs used to produce a certain good or service. Sales
revenues are the value of the sales within a period
irrespective of the cash inflow. The cash inflow within
a period is called income and can result from sales made
within the same period or in previous periods.
The appropriate cash flow figures from the real
sphere for liquidity planning and financial analysis in
the first production period are shown in the following
sum:
Incomes from sales of the first period
Expenditures for production costs with respect to
sales revenues, such as:
raw materials; labour; utilities; repairs; maintenance;
spare parts; factory overheads; administrative over-
heads; and sales and distribution activities
Expenditures for production costs with respect to
finished products inventories
Expenditures with respect to work in progress
Increase of cash in hand
Expenditures for inventories of maLerials, spare parts
and so on
Expenditures for fixed investment assets
Advance payments for purchases
t Advance receipts from sales
= Net cash flow (NCF)
Such a survey of the cash flow figures, however, is
not often available to the financial analyst. Usually at
this stage he has an estimate of the prospective sales in
the periods in the market analysis, and estimates of
different production cost items from the
technwconomic analysis. The survey developed from
this information relates the sales revenues of a period to
the associated costs of producing the quantities sold in
a period. These are basically the same figures as are
used in the income statement of a firm. It is part of the
task of the financial analyst to derive from this informa-
tion the relevant net cash flow figures.
The production cost estimate from the
technwconomic analysis can be arranged as follows
(UNDO, 1978, page 194):
Raw materials
+ Labour
+ Utilities
+ Repair
+ Maintenance
+ Spares
+ Factory overhead costs
= Factory costs
+ Administrative overhead costs
+ Sales costs
+ Distribution costs
= Operating costs
+ Interest
+ Depreciation
= Total production costs
Project Appraisal September 1989
Working capital in project evaluation
A short cut estimate of the net cash flow of a period from
these figures in standard textbooks is:
Sales revenues
- Total production costs
+ Depreciation
- Expenditures for fixed investment
~~
= NCF*
NCF* could serve as a reasonable approximation in
later periods for NCF, but, in the first period, there are
usually some greater discrepancies. Parts of the sales
revenues of the first period will not lead to income in that
period, they will result in receivables. On the other
hand, parts of the production costs like raw material
costs will not lead to expenditures in the same period,
they will form current liabilities.
If we neglect the financial costs which are of no
concern for our discussion we can reformulatc NCF* as
follows:
Incomes from sales revenues
+ Increase of receivables from sales revenues
- Total operating costs with respect to sales
- Increase of current liabilities
- Expenditures for fixed investments
= NCF*
With NCF* as a starting point we can now calculate
NCF:
NCF*
- Increase of receivables from sales revenues (receiv-
ables)
- Expenditures for production costs with respect to
finished products’ inventories (finished goods)
- Expenditures with respect to work in progress (work
in progress)
- Increase of cash in hand (cash in hand)
- Expenditures for inventories of materials, spare parts
and so on (raw materials and spare parts)
- Expenditures for fixed investment assets (fixed
assets)
- Advance payments for purchase (advance payments)
+ Advance receipts from sales (advance receipts)
+ Increase of current liabilities (current liabilities)
= Net cash flow (NCF)
The items making the difference betwecn NCF and
NCF*canbeidentified as theitemsofthe workingornet
working capital and fixed assets.
Linkage between periods
The discussion in the context of the cash flow figures
shows that the inventories of matcrials and so on arc
expenditures in the first period for such goods that do not
form part of the operating costs of that period. The
153
Working capital in project evaluation
inventories for finished goods and work in progress
represent expenditures for the production of these
goods, that is, expenditures for the incorporated inputs.
Receivables are a correction of the sales revenue
figures because they will lead to a corresponding cash
inflow only in the following periods. Current liabilities
on the other hand are a correction that is necessary
because some of the purchases of inputs like raw
materials and utilities will not lead to expendituresin the
same period.
The discussion up to now has dealt with the first
period only. In later periods the gross increase of most
items like inventories of raw materials and the increase
of receivables due to sales during a specific period, will
be balanced by a decrease of the respective stocks and
receivables. Some of the stock of raw material available
at the beginning of the period, for instance, is used as an
input within that period.
The expenditures for these materials, however, took
place in previous periods. Likewise some income
results from sales in previous periods. Hence, for cash
flow analysis it is most important to consider the in-
crease of net working capital in the first period and the
corresponding decrease after the last period.
Calculation guidelines
Some guidelines stress the importance of a proper
handling of working capital without any further sugges-
tion on how to calculate it (for instance, Asian Develop-
ment Bank, 1983). Duvigneau and Prasad (1983)
suggest estimating the different items as a specific per-
centage of the projected sales revenues or cost figures.
The percentage applied in such approaches can be
derived from experiences with recent projects by means
of an analysis of the balance sheets and profit and loss
accounts of existing firms, or fixed as a strategic deci-
sion. The latter is explicitly done in some guidelines
using the ‘minimum days of coverage’ approach (see
UNIDO, 1978; State Planning Commission of China,
1987; Sell, 1989). The suggestions wilh respect to the
procedures for the estimation of different items of
working capital and net working capital will be demon-
strated by some examples.
In computing material inventories as a strategic
decision, the minimum days or months of coverage have
to be determined. One month (or 30 days) of coverage
would mean a stock that would enable the project to
produce for one month with the planned capacity with-
For cash flow analysis it is most
important to consider the increase of
net working capital in the first period
and the corresponding decrease after
the last period
154
out any further purchase of the respective input. This
would result in a coefficient of turnover of 12 and in a
stock of materials of one twelfth of annual material
input, or 8.3%.
In all approachesa fine tuning by separatecalculation
for sub-groups of materials is suggested. Hence, in
general, for imported materials, the minimum days of
coverage will be significantly higher than for domestic
materials because of the greater probability of interrup-
tion in supply.
An average credit term of two months would result in
accounts receivables of two twelfths of the annual sales
revenues or 16.7%. The inventories in work in progress
depend on the duration of the production process and the
expendituresfor the inputs involved. Similarconsidera-
tions hold for the other items discussed (see for instance
UNIDO,1978, pages 155 ff).
To make the calculation, therefore, the minimum
days or months of coverage, the average credit term, the
duration of processing the goods or services and so on
have to be knownand, in addition,the relevant reference
basis. In our examples the reference figures are the
annual sales revenues for receivables, and for material
inventories the annual material costs.
As the synopsis of different guidelines in Table 1
shows, with the exception of materials, there obviously
is no consensus among experts on the proper reference
basis for most items of net working capital.
For accounts receivable, sales revenues and oper-
ating costs (production costs minus depreciation and
interest in the ICIS (International Centre for Industrial
Studies, UNIDO) approach is basically the same) are
offered as an alternative basis. The reason behind using
operating costs is most probably the idea that it takes
care of the incorporated cost figures. This at first glance
looks reasonable; however, from the discussion of re-
ceivables in the context of the cash flow analysis, it is
obvious that the incorporated costs are of no relevance.
The inclusion of receivables as part of working capital
is a correction of sales revenues by those sales that are
not yet realized in cash in that period. Thus, using
operating costs instead of sales revenue as a basis will
result in an underestimation of accounts receivable. It
will also lead to wrong numbers for the projected
balance sheet because it is common practice in account-
ing to value receivables at nominal values.
Concerning frnished goods and work in progress,
with the exception of the Duvigneauprasad approach, a
cost base serves as reference. This is in line with the
discussion of these items within the context of the cash
flow analysis. However, to include in the basis such
items as administrative overheads would result in
double-counting.
These costs are fixed, are included in the annual
operatingcosts and, therefore, are already considered in
the NCF. Therefore, the factory costs representing
mainly variable costs are the appropriate basis. Includ-
ing overhead costs in the basis would result in an
overestimation of the stock of finished goods. With
respect to work in progress we have to consider addi-
Project Appraisal September 1989
 Working capital in project evaluation

Table 1. Reference base used in different guidelines for calculating net working capital

items D/P' PCCb ICIS" Selld

Materials annual costs annual costs annual costs annual costs

Accounts sales operating costs production sales

receivable revenues costs revenues
- depreciation
and interest

Finished sales annual factory costs factory costs

products revenues production costs + administrative
inci overheads overheads
- depreciation

Work in sales annual factory costs factory costs

progress revenues production costs
- depreciation

Cash in hand sales total operating costs

revenues production costs - materials
- raw materiais
- utilities
- depreciation

Advance sales
payments revenues

Current costs of sales costs of materials, costs of raw costs of

liabilities - salaries and fuels and materials and materiais and
wages power purchases utilities utilities

Notes: Duvigneau and Prasad, 1984, pages 13,68,88.

b State Planning Commission of China, 1987, Annex Table 2.2
UNIDO, 1987, pages 194 ff.
t A Sell, 1989, pages 72 ff.

tionally that, depending on the production process, on
average only 50% of the costs are incorporated in these
products.
For cash in hand the existence of different bases is not
surprising, since it depends on the assumption relating
to those components which fluctuate the most. It is hard
to decide apriori which basis should be the relevant one
for a specific case.
In the case of current liabilities it is again a question
of the specific circumstances in which suppliers of input
items grant credits. The most prominent items will be
material inputs and utilities which accordingly are used
in three of the approaches. The restriction on raw
materials in the ICIS approach is only due to the fact that
purchased parts are not separated: there is, therefore, no
principle difference between this and the two other
approaches using a similar base.
The base used by DuvigneauPrasad includes depre-
ciation and other fixed cost components. Given the
With the exception of materials, there
are remarkable differences between the
suggestions concerning the base on
which to calculate the items of net
working capital
same assumption for the average number of days of
credit by the project's suppliers, current liabilities
would be overestimated and net working capital under-
estimated. There is no obvious logical link between this
base and current liabilities and, therefore, costs of ma-
terials and utilities are to be preferred as the base.
Most guidelines suggest making a separate calculation
for sub-groups of those inputs.
Conclusions
The different items of working and net working capital
are usually calculated as a percentage of projected sales
revenues or cost figures. The percentages applied are
very often indirectly fixed by the strategic decision
concerning the minimum days of coverage for material,
the average credit terms for sales and purchases of
inputs, the technical facts with respect to the duration of
the production process and so on. With the exception of
materials, there are remarkable differences between the
suggestions in literature concerning the base on which
to calculate the different items of net working capital.
It was demonstrated by the discussion of the different
items in the context of the cash flow analysis that, for
accounts receivables, annual sales revenues are the
proper basis. Using a cost base means an underestima-
tion of receivables for financial planning purposes and
for the projected balance sheet.

Project Appraisal September 1989 155

Working capital in project evaluation
For finished goods and work in progrcss, a cost base
representing at best the incorporated costs for producing
those items has to be applied. Contrary to the sugges-
tions in some guidelines, administrative overheads and
other cost items being fixed costs by their very nature,
are not to be included to avoid double-counting. The
expenditures for those costs are already considered in
the cash flow table by using annual operating costs as an
approximation for the annual expenditures.
For current liabilites, it depends on the specific cir-
cumstances which base serves best. Material inputs and
utilities are the most prominent items that should be
included.
For cash in hand, the base depends on the assumption
regarding which items fluctuate the most. Thus there is
no apriori reason to favour any particular approaches.
156
References
S H Archer, G M Choate and G Racette, FinancialManagement (John
Wiley & Sons, New York, Chichesterand Brisbane, 1983, second
edition.
Asian DevelopmentBank, GeneralGuidlines for EconomicAnalysis of
Projects (Economic Office, Manila, 1983).
J C Duvigneau and R N Prasad, Guidlines for Calculating Financial
and Economic Rates of Return for DFC Projects, World Bank
Technical Paper no 33 (Washington, DC, 1984).
A Sell, Investitionen in Entwicklungslandern. Einrel- und ge-
samtwirtschaftlicheAnalysen (lnvestment Projects in Developing
Countries. Financial and Economic Analysis) (Hamburg Institute
of Economic Research, Hamburg, 1989).
State Planning Commission of China, Methods and Parameters of
ConstructionProjects Economic Evaluation (Beijing, 1987).
UNIDO, Manual for the Preparation of Industrial Feasibility Studies
(UN, New York, 1978) (prepared by the International Centre for
IndustrialStudies of UNIDO).
Project Appraisal September 1989