Welcome

Working Capital Policy & Management

National Institute of Industrial Engineering
PGDIM Programme - 14th Batch

P. C. Basu
December 9, 2006

Proposed Plan for Presentation Learning Objectives

Basic Concepts Working Capital Cycle Factors Influencing WC Requirements Approaches Towards Financing Working Capital Working Capital Decision Focus Relational Analysis of Decision Variables Case Study
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Learning Objectives
Study and develop understanding about the following Basic Concepts Elements of Working Capital Movements through Business Operation Steps for Management Decision Focus Factors Influencing Requirements Management through Ratio Analysis

Research finding on Entreprenurship in India

Indian entrepreneurs have much higher working capital requirements. A US entrepreneur can at least hope to collect receivables in about 30 days. In India they extend receivables to 90 days or longer.
Prof. Amar Bhide
Lawrence D. Glaubbinger Professor of Business Columbia Business School, USA

Source: Indian Management, November 2007

Working Capital Basic Concepts

Target - where to go from where ??

Zone - A

Zone - B

% age Change in Turnover

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Working Capital - Basic Concepts What is Working Capital ?

Money or fund required for Conducting business operation in order to Generate Products or Services

What is WC Management Six Rs

Providing the

Right quantity of fund For the right composition of elements At the right time With the right mix of sources At the right cost With right security against borrowing

Working Capital - Basic Concepts 2 What is the form of Working Capital and how does it change?
Cash or its equivalent Takes the form of an asset - Tangible or Intangible Transforms as it moves from one operation to other Can quickly be converted to cash at any stage Hence called Current Assets Does not retain the same form/ status for long

Delay in converting to cash means loss

Working Capital - Basic Concepts 3 Types of Working Capital

Gross Working Capital - Total operating fund Net Working Capital - Total operating fund reduced by supplies in credit by vendors and business associates

Constituents of Gross Working Capital Current Assets (CA) of the following nature
Inventory
Raw Materials and Input Services Work-in-Progress Finished Goods and Output Services Spare Parts & Consumables

Debtors - Receivables from Customers and Bills Loans & Advances - to Suppliers and Employees, Investments for regular trading Cash & Bank Balances
More profit if rolls over more number of times in a year
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Working Capital - Basic Concepts 4 Constituents of Current Liabilities (CL)

Credits from Suppliers of Inputs and Services Advances from Customers Payables to Employees Instalments of Long Term Liabilities payable within one year Borrowings of short term nature Bank Overdraft Provisions Net Working Capital
Gross Current Assets Less Current Liabilities

This is also know as Net Current Assets

Suppliers credit may cost through price
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Working Capital Cycle

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Working Capital Cycle

13 Close interaction among WC components implies efficient management

Operating Cycle & Cash Cycle

Order Placed Stock Arrives for Inputs Inventory/ Mfg. Period Cash Received

Accounts Receivable Period

Accounts Payable Period Suppliers Invoice Received

(Self Financed Materials)

Cash paid for Materials Operating Cycle

Cash Cycle Compare cost of capital of the company with that of suppliers
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Operating Cycle & Cash Cycle

Order Placed Stock Arrives for Inputs Inventory/ Mfg. Period Cash Received

Accounts Receivable Period

Accounts Payable Period

Suppliers Invoice Received

( Part of Receivables serviced by supplier)

Cash paid for Materials Operating Cycle

Cash Cycle Higher rate of materials may mean interest added by suppliers 15

Factors Influencing Working Capital Requirements and Fluctuations

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Factors Influencing WC Requirements

Nature of Business
Manufacturing - Capital Goods, Consumer Durables, FMCG Servicing - IT, Telecom, Entertainment, Leisure, Transport Financial. Services Banking, Mutual Fund, Insurance Construction Housing, Roads & Bridges, Industrial Units

Seasonality of Operations - e. g., Sugar Industry Corporate Policies - Procurement, Production, Marketing, Financing Market Segment - Local, State Level, Regional Export Customer Segment Consumer, Industrial, Government Socio-economic condition and availability of funds Input Market Conditions availability, competition, etc. Trade Practices - Prepaid (Railways), Credit - Govt. Output Market Conditions severity of competition Socio-political events one off kind
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Working Capital Variations

Optimal Amount (Level) of Current Assets
Assumptions 50,000 maximum units of production Continuous production Three different policies for current asset levels are possible

ASSET LEVEL (RS/ Cr.)

Policy A
Policy B Policy C

Current Assets

25,000 OUTPUT (units)

50,000
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Impact on Liquidity
Optimal Amount (Level) of Current Assets
Liquidity Analysis Policy Liquidity A High B Average C Low Greater current asset levels generate more liquidity; all other factors held constant.

ASSET LEVEL (Rs/ Cr.)

Policy A
Policy B Policy C

Current Assets

25,000 OUTPUT (units)

50,000
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Permanent Working Capital

The amount of current assets required to meet a firms long-term minimum needs.

W. C. - Rs./ Cr.

Permanent current assets

Growth in Operations

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Temporary Working Capital

The amount of current assets that varies with seasonal requirements.

Temporary current assets

W. C. - Rs./ Cr.

Permanent current assets

Growth in Operation

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Working Capital Management & Approaches and Policies for Financing

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Management = Decision making

Implementing Evaluating achievements vs. preset goals Record learning experience

Go ahead with the next event

The journey goes on and on and on
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What is Decision Making?

Selection of the best course of action amongst alternatives
A plan can not be said to exist unless resources are committed and directions are given to go ahead with execution

Assess risks and plan for mitigation measures

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Steps in Decision Making Process

General Management Point of View
1. Define objectives/ goals to be achieved 2. Define the problem to be resolved and its after effects

3. Study internal and external environment and realities

4. Develop alternative courses of actions 5. Give due considerations to the limiting factor(s)

6. Select the appropriate decision making tools

7. Visualise resource requirements for executing the decision 8. Understand differences between decisions made and to be

executed under conditions of:

- Certainty, Uncertainty, or Risks 9. Understand the need and importance for creativity / innovation
10.

Evaluate the defined alternatives and choose the best one

Relevant information is required at each step

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Approaches for Selecting out of Decision Alternatives

Experimentation

Reliance on the past

How to select from alternatives

Choice made

Creative

Research and Analysis

Intuitive

Evaluation of decision alternatives will differ with the approaches

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Decision Focus - Ten Commandments

1. Restore financial equilibrium - Deployment Vs. Operating Volume 2. Financial discipline and control Credit to Customer vs.from Vendor 3. Identify and remove inefficiencies in Value Chain (Example IOC) 4. Drive Cash Flow with periodical and time bound targets 5. Set a logical framework for redeployment of liberated cash inflow

6. Develop cross-functional business cases for improving WC performance (Case Study)

7. Align goals of both Supply Chain and WC Management
8.

9. Integrate Operating Systems with Financial Systems for stronger and effective decision support system 10.Continuous vigilance on Conversion Time from one type of Current Assets to the next type in the chain

Tailor make the commandments and follow with passion

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G. H. Hofsteds Graph for Employee Behaviour in the Process of Target Setting

Management Expectation A c h v e m e n t s

Employee Performance

Easy Efforts

Difficult Impossible Perception of Employees / Management

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Approaches for Financing Working Capital

Tandon Committee Recommendation
25% of Net Current Assets to be financed by owner

Chore Committee Recommendation

25% of Gross Current Assets to be financed by owners

Cash Flow Approach

Gap between inflows and outflows to be financed by bank

Margin Approach
Bank shall provide funds equivalent to Net Working Capital Less Margin on Current Assets - Say 25% of Debts, 20% of Inventory,

Flexible Equivalent Days Approach

70% of Holding Value of Current Assets - Rolling Projection Basis
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Approaches for Financing Working Capital .. 2

Aggressive Policy

More short-term finance is used to fund CAs Borrowing short-term is considered more risky than long-term. Firms risk increases, due to the risk of fluctuating interest rates, Potential for higher returns increases because of low-cost financing
Conservative Policy

Finance some of permanent CAs by expensive long-term Debt and Equity Decreases potential for maximum value creation Relatively a low risk proposition. Safety of conservative approach has a cost
Moderate Policy

This approach tries to balance risk and return concerns. Temporary CAs to be funded by short-term debt, current liabilities. Permanent CAs to be funded from long-term debt and equity The firm to have a moderate amount of net working capital. Risk is balanced by a relatively moderate amount of expected return.
Adopt the Policy which suits the business most in the given situation
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Relational Analysis of Decision Variables

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FINANCIAL RATIO ANALYSIS Short Term Strength & Stability - Liquidity S hort Term Liquidit y / Financing of Working Capit al Name of R at io Current Ratio (w/o S. T . Loan) Current Ratio (with S. T . Loan) Quick Ratio Formula Gross Current A sset s ( GCA ) Gross Current Liabilit ies ( GCL) Gross Current A sset s GCL + Demand / S .T. Loans Liquid Assets Gross Current Liabilities Liquid Assets = GCA - Inventory Debtors more than six months Loans to Employees (Assuming - 0) GCA to Net Worth S. T . Loans to GCA Gross Current A sset s Net Wort h Cash Credit + P acking Credit + Ot hers Gross Current Assets Other S.T .Loans = Commercial Paper + Inter-corporate Loans + Other Sources MPBF to S T B ank Loans Maximum Permissible Bank Finance Cash Credit + P acking Credit , et c. Maximum P ermissible B ank Finance Gross Current A sset s Less : Current Liabilit ies = Net Current A sset s Less : 25 % of GCA = MP B F A ccut al S hort Term B orrowing 1.55 1.70 2.06: 1 2.70: 1 05 - 06 4.09 : 1 04 - 05 4.68 : 1

1.75 :1

1.89 : 1

2.49: 1

2.77: 1

32.66%

31.58%

625.50 153.00 472.50 156.38 316.13 204.30

522.50 111.65 410.85 32 130.63 280.23 165.00

FINANCIAL RATIO ANALYSIS Short Term Strength & Stability Working Capit al Management E fficiency Name of R at io Gross Working Capit al Turnover ( Times) Formula Gross Turnover Gross Current A sset s Gross Turnover = S ales Value + E xcise Dut y, if not included + S ales Tax Net W. Capit al Turnover ( Times) Gross Turnover Net Working Cap. ( Net CA s) 2.59 2.61 05 - 06 1.96 04 - 05 2.05

Invent ory Turnover FG Stock X T otal D ays i n Peri od Finished Goods Cost of P rodn. of Goods S old ( Fact or Days) R aw Mat erial ( Times) Debt ors Turnover ( Fact or Days) Defensive Int ernal R at io ( Times)
C red i tors' T urnover (Matl s. Factor D ays)

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Cons. of R .M. During t he P eriod S t ock of R M at P eriod E nd Debt ors X Tot al Days in P eriod Gross S ales Value Liquid Current A sset s Cash R equirement s per day
C red i tors f or Matl s. X N o. of D ays

2.98

3.28

102

99

179

165

68

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Gross P urchase Cost Gross P urchase Cost = P urchase value at net landed cost of mat erials + Levies and charges included in Creditors

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A Case Study

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Case Study on Working Capital Management

Loan of Bank turned NPA
E-0 E-2

Supply of Materials

Manufacturer
20% of Bill Paid
E-3 E-1 E-7

P. O.

F. G.

Bank Escrow A/c

100% Payment
E-4

70%
E-6

Material Supplier

Purchaser

Confirmation for Payment to Escrow A/c

E-5
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E = Event of Transaction

Thus spake the Wise Man

Good beginning is half done

Be Clear about your objectives

Think twice before you do No risk no gain
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?
Your questions
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Thank You Very Much Indeed

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