A brief on Working Capital Management

Any business requires investments and this could be broadly classified as Long-term Assets, like the Land, Building, Plant&Machinery etc which are mostly permanent in nature and Short Term assets which are also called Current. Assets represented by Inventory, Receivables, Advances, Cash and Bank balances. The Operational Liquidity is measured by its Net Working Capital which is nothing but Current Assets (Stock, Debtors etc) less Current Liabilities (Accounts payables and the current dues (i.e. dues within 12 months) of the Debt obligations). Working Capital is important for any business. A company could have the state of the art equipments to manufacture goods which has a huge potential market but unless they have the Raw Material to use in manufacture of finished goods, they cannot produce and sell their goods in the market. Thus a company could have a good product, machinery to make them and a good margin on their products but unless they have the liquidity they cannot finance the production and selling activity. In the Indian context working capital plays a crucial role in the success of any business and the pressure on the working capital is very high which can be broadly attributed to: A. Limitation in the available resources-most businesses are small/medium and are mostly family owned, limiting their ability to mobilize the required resources. The meager own resources are just adequate to meet the margin requirements that are essential to raise funds (both Long-term and Short-term) leaving very little to fund the day to day operations. 1. B. The cost of borrowing is relatively high and the size of Investment is governed by the ability of the business to service the high cost of borrowing. 1. The risk assumption potential is restricted to own resources which are relatively small and consequently reflects on the size of the Investment and as a practice the Indian business is always starved of working capital due to large dependence on Trade Creditors.

C. The business practices also have a strong influence on working capital management. The WC cycle is relatively large-High Inventory, Large Receivables and huge Sundry Creditors and these invariably results in large short-term bank borrowings like the Overdraft/Cash Credit, Bills Receivables and payables.

D. To summarize, working Capital is the net of Current Assets and Current Liabilities and a positive NWC denotes a healthy situation while a negative NWC reflects difficult business conditions.
What is WC management

As said earlier WC is the life line for any business and a negative NWC denotes sickness. High Inventory and Receivables funded by high levels of Sundry Creditors and short-term bank borrowings is a very common scenario in India-

Why does this happen: a. Flabby Inventory reflects poor WC management. Low stock turnover, High obsolescence, Procure to Stock rather that to Produce, uncertain supply conditions, volatile prices resulting in Holding beyond requirements are the common reasons for a high stock holding resulting in poor turn. b.Internationally, the collection cycle for receivables is between 15-30 days while 60 days is the norm in most businesses in India and 90 days payment terms are not uncommon. This locks up the WC funds to a very large extent resulting in increased bank borrowing or alternatively high Creditors holding. The business has no liquidity to pay its creditors on time and in most cases the large creditors holding is more by default rather than by design. c.Low promoters contribution, poor margins and high interest rates are the common causes for the need for large short-term funding for most business which causes in most cases low or negative working capital impacting liquidity and operations. The profit plough-back is not adequate to sustain the growth in the working capital needs.

The essence of WC management is to have a high turn ratio with focus on minimal Stock and Debtors. Having a right level of Inventory is a challenging task, striking a balance between Operational needs, commercial expediency and accepting the challenges of Demand and Supply vagaries.

Let us look at some examples impacting the Stock Holdings: 1. A typical manufacturing unit engaged in the production and sale of engineering goods using Iron & Steel would normally have an Inventory holding of 30-45 days consumption. The typical Holding will be about a week to 10 days as Raw materials, 15-20 days as Stock-in-process and about a week to 10 days of Finished Goods.

The logic or the practice here would be that it normally takes a week-10 days for delivery of Iron & Steel products and to ensure that the Plant has uninterrupted supply-chain, the unit would like a buffer of at least one weeks needs as RM to protect for any delay in delivery. The relatively large WIP is typical to India Industry-the Investment in Equipments are minimal and more often than not a single production line would cater to the various Product range necessitating frequent set-ups resulting in numerous StopStart sequences. This results in large WIP at various stages of operation. Depending on the customer preassure, market needs and RM availability the material in line is taken for finishing thus resulting in large stocks in process.

Finished Goods would invariably be low and in most cases the Fg holding would be due to trucking delays or logistics related. Sticking a fine balance between these would be a challenge for any Manager-if he holds less it could result in line stoppages impacting production losses and waste of precious Installed Capacity while on the other hand he wants to be safe in not holding up Production he has the risk of high interest cost, storage issues and related inefficiencies of a flabby inventory.

2. If the business is manufacture of Garments, the Para meters for Inventory holding could be different. Such Industry would mostly have a low RM and inprocess stock but would have a high Finished Goods Inventory. They would have to have their goods ready for sale and wait for the customer to buy. They would have a number of retail points and would need to maintain a certain minimum stock levels at the various centers thus bloating their FG stocks. The production cycle may not be high but the FG holding would be very high and in such conditions the Inventory management would be more under the marketing dept.Here the balance that needs to be arrived at monitoring the risk of obsolescence would be primary. An entire batch of FG may have to be scrapped if the design goes out of fashion.

3. We have seasonal Industries like the Sugar. Here the aim would be to procure as much cane as possible when it is available and ensure maximum capacity utilization. Such industries would not have any RM or WIP but would have very large FG at the end of the crushing season. These industries would produce the maximum during the season and sell the FG over a period of time.

We have thus seen that there is no single universal rule to control inventory and it varies from industry to industry and between companies within the same industry. In each of the examples given above the Holding pattern and Norms would be different.

The basic rule would perhaps be that minimum stocks which does not impact operations. As regards the Receivable cycle, this again varies between industries and between companies under the same industry. It is mostly governed by trade practices and the individual ability to negotiate for a lower collection cycle.

For e.g., Cement and Steel is generally sold against cash since demand is more than its supply. Such companies will have very low Debtors and will have a good liquidity position.

A high liquidity position would enable the Company to pay off its creditors early and thus would have positive NWC and the converse would be companies with large Inventory and Receivables would have locked up its funds and will have low liquidity and cannot pay its creditors and could have a low/negative NWC.

How is WC funded in the Indian context

Commercial banks in India essentially are meant to fund short-term requirements of business while the Term lending institutions like the IDBI,IFCI etc support the LT needs of the business. This is the broad principle under which they operate but the line is crossed quite frequently. Commercial Banks provide ST funds essentially for the WC needs of business and they have many facilities to offer depending on the Borrower, the nature of business and the operating cycle. The most common of these are the Overdraft or Cash Credit, Bill Discounting limits etc and these are called Fund based limits.

How does the Bank fix such limits

They assess the WC need of the borrower and it is generally fixed in terms of No of days holding of Stock and Debtors and also quantifies the ability of the borrower to access Trade Payables. This would vary from Industry to Industry and also Company to Company.

As a first step the Banks quantify the Working capital gap,ie,Gross Current Assets less the Current Liabilities. This should obviously be positive and the Gap would be amount they would provide as CC or OD. However, as a matter of prudence and to ensure adequate liquidity in the business the banks generally insist on a Current Ratio 1.33,ie,the Current Assets should be at least equal to 1.33 times the Current Liabilities including the ST working Capital funds provided by the banks. This in actual practice would mean that the business provides a margin of at least 25% of the Gross Current Assets and the balance would be provided by the bank. Greater than 1.33 times is healthy and less than that would in theory mean that there is excess dependence on bank .The following Table would explain how the Bank would appraise a working Capital limit:

Description

Rs Lakhs Example 1

No of

Rs Lakhs Example

No of

Rs Lakhs Example

No of

Days

Days

Days

Gross Current Asset

Inventory Receivables Others(Cash and Bank)

500 800 150

60 48

700 900 50

84 54

800 1200 10

96 72

Total Current Assets

1450

1650

2010

Current Liabilities: Trade Payables Statutory dues(PF,ESI,Taxes etc) Others(Salary/Wages,Power<Rent etc) TL Installments (due in next 12 months) 100 100 150 20 20 50 350 20 46 550 20 73 1800 30 238

Total Current Liabilities

490

690

2030

Working Capital Gap

960

960

-20

Bank CC/OD

600

600

600

Total Current Liabilities

1090

1290

2630

Current Ratio

1.33

1.28

0.76

Operating Statement Gross Sales 6000 6000 6000

Less: Cenvat Net sales

1000 5000

1000 5000

1000 5000

Material Consumption Operating Expenses

3000 1000

60% 20%

3000 1000

60% 20%

3000 1000

60% 20%

Total Cost

4000

80%

4000

80%

4000

80%

Gross Profit

1000

20%

1000

20%

1000

20%

In the Table above, Example 1 would be the ideal situation with positive NWC and a C/R of 1.33. It has just about 60 days of Inventory, Receivables at 48 days and Trade payables at about 46 days. Its liquidity is good and can meet all its ST commitments including TL obligations without any problem In the example 2 though it has positive NWC its liquidity is not as good as in 1.Both its Inventory and Receivables holdings are high at 84 and 54 days respectively and consequently has a large Trade Payable at 73 days. There is a mismatch in its collection cycle and payment cycle essentially due to large Stock Holding and higher Debtors. It would have liquidity issues and would default in its payment commitments which would disrupt its supply chain and consequently the Production cycle. Example 3 is a typical case of WC mismanagement-Highly bloated Inventory large Receivables resulting in huge Creditors. It has very poor liquidity and would be defaulting Creditors payments,TL Installments and even Statutory obligations. It will have difficulty in the day-to-day operations and from the banks view a potential Non-performing asset. The CC/OD is generally secured against Stock and Debtors with a margin of 25-

30%. In addition to this prime security there could be collateral or additional security by way of Mortgage/Hypothecation of Fixed Assets like Land, Building Plant&Machinery etc. Drawing Power calculation: Rs D P Computation Lakhs Exampl e1 Gross Current Asset Rs Lakhs Exampl e2 Rs Lakhs Exampl e3

Inventory Receivables Others(Cash and Bank)

500 800 150

700 900 50

800 1200 10

Total Current Assets

1450

1650

2010

Current Liabilities: Trade Payables 350 550 1800

Net Free assets

1100

1100

210

Less: Margin @ 25%

275

275

53

Eligible DP

825

825

158

Bank Outstanding

600

600

600

While E.g. 1&2 have comfortable DP E.g. 3 reflects drawl beyond DP and thus irregular. While computing the DP slow/non-moving Inventory should not be reckoned. Similarly the age of Debtors is also important. Normally Debtors beyond 90 days would not be considered for DP. If creditors include Capital Creditors they could be deducted from the Trade Creditors to arrive at DP.

All discussions so far has been on CC/OD since it is the most common form of bank facility for working capital. There are other facilities too like: 1.Bill Discounting- For good borrowers having relationship with reputed businesses Banks sanction a Bill limit,ie,their Sales receivables are credited to the borrower on submission of Invoice and a few other documents like the LWB,Accepted Hundi etc.By this the seller realizes the bill value immediately and the bank would receive the payment from the buyer o the due date, which could be 60/90 days depending on the usance agreed between the buyer and the seller. The accepted documents would be the security for this facility and generally will have a lower margin of 10% or even Nil in most cases. Banks will collect a discount charge for the usance period which would be marginally lower than the CC/OD rate. The facility will have a recourse clause to the buyer,ie,in the event of the seller not paying on the due date,the buyer has to repay the amount. 2.Business engaged in Export of Goods would be eligible for Packing credit which is very similar to the CC except that it carries a lower interest rate. This is granted against confirmed export orders and two types of facilities are granted,viz,Pre-shipment credit which is to facilitate procurement and manufacture of the exportable goods and up to 90% of the Order value is

released on submission of the order which would on actual export would be converted to Post-shipment limit for the full Bill value. This operates similar to the bill discounting limit explained earlier. Banks generally encourage such borrowers to cover their export receivables thro a Forward contract as a hedge against risks of exchange fluctuations. By this the exporter is assured of the exchange he would be entitled to and is not left to the uncertainties of the forex market. Working capital Management is a complex problem both from the business point and the bankers ability to monitor a facility. It requires a good understanding of the economy in general, the practices in the Industry, the internal policies of the business etc. The survival of any business is largely dependent on the effective management of its WC needs and hence it is important to understand the issues involved in it

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