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                  Working Capital Management

MANU

CONVERSATION

BETWEEN

MANU AND VINU

ABOUT

WORKING CAPITAL MANAGEMENT

VINU

 

Manu

Hi Vinu, How are you? How is your new job?

Vinu

Hi Manu. I am fine. But my job brings me nightmares!

Manu

Why? What’s the problem?

Vinu

I am entrusted with job of reviewing Working Capital Management system in my organisation and to give suggestions to improve the same. I don’t know even the basics of Working Capital. Don’t know how i am going to do it!

Manu

Don’t worry. I’ll take you through the basics of Working Capital Management. It’s all common sense. You can do it.

Vinu

Thanks Manu for confidence building. But tell me, why business entities pay so much attention on Working Capital Management? Is it worth the efforts?

Manu

Absolutely Yes Vinu. You would appreciate it better, if u come across companies which continue to operate regularly despite incurring heavy losses. Some companies, despite reporting good amount of profits, they would find it difficult to continue their operations.

Vinu

Yes. I have come across. It also makes me to think that those entities are giving false accounting reports. How can an entity making profits will become unable to operate? Why is that?

Manu

It’s because of their Working Capital Management. Good Working Capital Management will enable business to grow, where as poor WC Management will put a halt to the operations.

Vinu

Can you explain that in detail?

Manu

Let us assume you want to start a business. Let’s think a big amount. So how much you will be investing?

Vinu

Say, Rs.10 Crores.

Manu

Fine. That’s a good start. Now, the amount you invest in the business will be in the form of Capital. So what are the assets you will be acquiring with the capital?

Vinu

I would acquire Land & Building for Factory, Plant and Machinery for Production purposes and Furniture and Fixtures.

Manu

Are you sure?

Vinu

Yes.

Manu

Then please assign value for each and every item.

Vinu

Particulars

Rs. In Cr.

Land and Building

3.00

Plant and Machinery

6.00

Furniture and Fixture

1.00

Total

10.00

Manu

So, your balance sheet should be looking like this:

Liabilities

Rs. In Cr.

Assets

Rs. In Cr.

 

Capital

 

10.00

Land and Building

3.00

Plant and Machinery

6.00

Furniture and Fixture

1.00

Total

10.00

Total

10.00

Vinu

Correct!

Manu

So now with this investment, your Factory is ready.

Vinu

Yes!

Manu

With this you can start the production.

Vinu

Absolutely.

Manu

Fine. Now a buyer is visiting your factory. He is satisfied with your Factory and Production facilities. He wishes to buy product from you. He would like to place order. Will you be happy?

Vinu

Yes. I should be!

Manu

No! You shouldn’t

Vinu

Why?

Manu

How will you meet the expectation of the customer?

Do you have Raw Materials?

Do you have labourers to work in factory?

Do you have cash to meet operating expenses?

Vinu

God!!!!

I don’t have any of these.

Manu

Why did this happen to you?

Vinu

It happened because I have used all my capital for creating long term assets. I never gave thought on capital required for working purposes.

Manu

Exactly. You have not assessed what is the capital required for your working purposes. You focussed only on creating long term assets. This is the mistake many entrepreneurs were doing!

Vinu

Ya! Now I understand. The capital that is required for working of an Organisation is called Working Capital.

Manu

Correct. But don’t jump for conclusion. Let us understand this in detail.

Vinu

Ok!

Manu

We stopped, when customer is ready to place order. Is that right?

Vinu

Right.

Manu

Ok. Let’s say, the customer is placing order for products worth Rs.5 Crs. So what you should do now?

Vinu

I should purchase Raw Materials.

Manu

Let’s say it would be around 60% of Sales Value.

Vinu

Ok. So the Raw materials value Rs.5 Cr x 60% = Rs.3 Cr

Manu

Correct. Then you should engage labourers, consume power, and incur other manufacturing expenses. Let’s assume the cost of all those would be around Rs.1.50 Cr

Vinu

Ok.  So my total cost of production is

 

Raw Materials = 3.00 Cr

Other Costs     =  1.50 Cr

-------------------------------

Total                 =  4.50 Cr

-------------------------------

Manu

Correct. Your expected profit will be

Sales Value = 5.00 Cr

Less: Cost    = 4.50 Cr

---------------------------

Profit           = 0.50 Cr

---------------------------

Vinu

What I understand is, without arranging capital for this Rs.4.50 Cr, I cannot produce products to meet the expectation of the customer.

Manu

Exactly. You can’t even make use of your factory, its infrastructure, furniture, etc.

Vinu

Yes. It is like fuel for a car. Without out fuel car is useless. Then is this my Working Capital?

Manu

May be termed as Initial Working Capital. To kick start the production process.

Vinu

So do you mean, Working capital will undergo change?

Manu

Yes. Understand the following carefully:

  • You have to incur Rs.4.50 Cr to produce the products required by the customer.
  • Let’s say you keep certain stock of Raw Material for one month and your production process takes one month time. It means your funds are locked for two months.
  • But that’s not the end of it. The customer, who has ordered, requires one more month to take delivery. It means you have to carry the finished goods for one month. So your funds are locked for three months (i.e, in Raw Material, in conversion process and in Finished Goods).
  • What is the guarantee he will pay it in cash immediately? Say, the customer needs one month credit. So your funds are locked for four months.

Vinu

Yes. I am not going to get back this Rs.4.50 Cr for next 4 months.

Manu

Yes. This is your working capital cycle. The time involved between cash payment for purchase of raw materials and cash receipt out of sale proceeds.

Vinu

So do you mean, I have to make investment of Rs.4.50 Cr along with my original investment of Rs.10 Cr? That’s big amount? How do I manage?

Manu

It’s not necessary you have to make all the investment! You may get support of some outsiders.

Vinu

Like?

Manu

Sundry Creditors, Bankers etc

Vinu

Can you please elaborate on that?

Manu

Now you understand your funds were locked for 4 months and its value is Rs.4.50 Cr. You cannot afford to wait for sale of above products, get money and start another batch of production. If you do so, you will be doing only three cycles in a year(12 months / 4 months) and your turnover will be just Rs.15 Cr (Rs.5 Cr/4 months x 12 months).

Vinu

Agreed! I can visualise that. I should move on. I should get support from others to ensure continuous production!

Manu

Ask your Raw Material suppliers to give you credit for 1 month. Your Raw Material cost is Rs.3.00 Cr. So, you get funding support their for one month!

Your other costs comprise Labour, Power, Manufacturing Expenses. Pay these costs by month end.

So, you enjoy one month credit for all your expenses.

Vinu

Yes. It means my funds were not locked for 4 months but only for 3 months.

Manu

Exactly. You got that right. You need funding support for 3 months only. Because, support from creditors will reduce your need for capital.

Vinu

Got that point!

Manu

Let us annualise the assumptions:

  1. Your sales order was Rs.5.00 Cr.
  2. Let’s say these sales would take place every month.
  3. So your annual sales should be Rs.5 Cr x 12 months = Rs.60 Crs
  4. Your raw material cost is Rs.3 Cr x 12 months = Rs.36 Crs
  5. Your others costs were Rs.1.50 Cr x 12 months = Rs.18 Crs
  6. Your profit is Sales (60 Crs) – Cost (54 Crs) = Rs.6 Crs
  7. You may have to keep one month raw material as stock – Rs.3 Crs
  8. You understand your production process takes one month time period. Your total production cost is Rs.54 Crs for 12 months. Total production cost per month is Rs.4.50 Cr. So funds locked in production are Rs.4.50 Cr.
  9.  You have to keep the finished goods for one month – So its value is Rs.4.50 Cr.
  10. Again, customer would take one month time to pay you back. Your monthly sales is Rs.5.00 Cr but cost is only Rs.4.50 Cr. You need funding support only for the cost and not for the profit. Mind that!

Vinu

Ok. Let me tabulate the areas, where funds are locked.

 

Particulars

Holding Level

Value (Rs. In Cr)

Raw Material Stock

1 Month

 3.00

Process Stock

1 Month

 4.50

Finished Goods

1 Month

 4.50

Receivables

1 Month

 4.50

Total

4 Months

16.50

Correct me if i am wrong.

Manu

You are right, but you have not factored the credit available from Raw Material Suppliers and others.

Vinu

Yes! I recollect. Raw Material suppliers were ready to extend credit for one month and other expenses were also paid in monthly intervals. It means we have one month funding support

Raw Material Monthly Purchases = Rs.3 Crs

Other Monthly Expenses                = Rs.1.50 Cr

Manu

Good! Factor them in your table.

Vinu

 

Raw Material Stock

30 days

 3.00

Process Stock

30 days

 4.50

Finished Goods

30 days

 4.50

Receivables

30 days

 4.50

Total

120 days

16.50

Less:

 

 

Sundry Creditors

30 days

(3.00)

Other Expenses

(1.50)

Working Capital

90 days

12.00

 

Manu

So now, you appreciate that regular funding support required is for Rs.13 Crs only and not Rs.16.50 Crs.

Vinu

Yes! But it’s alarming now. I was wondering how Rs.4.50 Cr will be brought in as capital for Working Capital. But now you the picture is Rs.12.00 Cr

Manu

Yes.

This is the reality which many companies fail to realise. They will have very little provision for Working Capital which will significantly affect their efficiency and performance.

Vinu

I agree with that! But Working Capital required for this company is huge now and beyond our means! Why it is so heavy?

Manu

It is because,

Always you have to keep one month stock of raw materials.

Your process is also one month.

You want to hold finished goods for one month.

You cannot tell your customer you will not give credit.

Vinu

Then what is role I have to play in my organisation? When working capital is pre-determined by all these levels, what I can do further?

Manu

You can! You have to revisit the holding period of all the above.

Vinu

How?

Manu

You have to check whether the company is actually required to maintain one month level of stock. Is it Economic Level? Whether the company is going to incur idle cost for holding Raw Material for One Month? What are the Pros and Cons? Identify? Test whether Economic Order Quantity / JIT are being applied?

Vinu

Correct. I have learnt these techniques in costing.

Manu

Then apply that in Working Capital Management. Probably, the study of Raw Material holding period may tell you, 10 days stocks of Raw Material may be sufficient.

Vinu

True. If my Raw Material holding is 10 days only, my investment in Raw Material will become Rs.1 Cr against Rs.3 Cr.

Manu

Well said! Then also explore ways for reducing processing time. Now you take one month for processing the product. Explore ways to reduce that.

Vinu

Ok. I’ll engage technical team and will bring down the time period to 20 days from 30 days.

Manu

So now you have investment of Rs.4.50 Cr in process stock for 30 days. It will become Rs.3 Cr for 20 days.

Vinu

Ya...That’s savings by Rs.1.50 Cr

Manu

Now also explore ways for reducing finished goods holding level from the present 30 days. Effective marketing strategy would bring more customers and so you may not be forced to keep finished goods in stock for 30 days. Target 15 days Finished Goods only.

Vinu

Ok. So my investment in Finished goods should be Rs.2.25 Crs against Rs.4.50 Cr

Manu

Negotiate for better credit terms with customers. Also explore offering them cash discount if they are ready to make rapid payments. This would bring down the credit period. You should target in such a way it comes down atleast by 10 days.

Vinu

Ok. If I do that, my debtors will come down from Rs.4.50 Cr (30 days) to Rs.3.00 Cr (20 days)

Manu

Since, you are doing all these downsizing you may not get much support from your creditors. So find out what would be your revised working capital.

Vinu

Let me do that!

Particulars

Old Working Capital

New Working Capital

Raw Material Stock

30 days

 3.00

10 days

1.00

Process Stock

30 days

 4.50

20 days

3.00

Finished Goods

30 days

 4.50

15 days

2.25

Receivables

30 days

 4.50

20 days

3.00

Total

120 days

16.50

65 days

9.25

Less:

 

 

 

 

Sundry Creditors

30 days

(3.00)

30 days

(3.00)

Other Expenses

(1.50)

(1.50)

Working Capital

90 days

12.00

35 days

4.75

 

Manu

 Look at the difference!

Vinu

Wow...That’s significant drop from Rs.12  Crs to Rs.4.75 Crs. Whopping Rs.7.25 Cr

Manu

Yes. That is possible, when you review each and every item of your working capital components critically

Vinu

Now I understand my responsibility for my new assignment. I’ll review the present working capital composition and would advice my management accordingly.

Manu

That’s great. When your working capital requirement comes down because of judicious investment in components of WC, it would bring sizeable savings in cost and improve the overall profit margins of the company. But you should also keep in mind, low working capital also has risk associated with it.

Vinu

What is that?

Manu

Its opportunity loss. You may be missing some new customers or additional orders because of low level of inventory holding. If you be rigid on your credit terms, customers may jump to competitors.

Vinu

Understood! So we have to strike a balance and reach what is known as Optimum Working Capital.

Manu

Great. You got the theory and logics behind Working Capital Management.

Vinu

Still something is troubling me.

Manu

What is that?

Vinu

Whether Working capital should be invested only by the owners?

Manu

Not necessary.

Vinu

Please explain.

Manu

You have arrived your working capital like this:

Raw Material Stock

10 days

1.00

Process Stock

20 days

3.00

Finished Goods

15 days

2.25

Receivables

20 days

3.00

Total (Gross Working Capital)

65 days

9.25

Less:

 

 

Sundry Creditors

30 days

(3.00)

Other Expenses

(1.50)

Working Capital

35 days

4.75

 

  • Your Gross Working Capital is Rs.9.25 Crs of which Rs.4.50 Cr has already been funded by Sundry Creditors and Others Expense Providers.

Vinu

Correct!

Manu

  • Balance Working Capital of Rs.4.75 Cr should be funded.
  • It can be funded partially with the support of Banker.
  • Generally, Bankers will be funding 75% of WC assets which is Rs.9.25x75%= Rs.6.94 Cr.
  • Since, Creditors and others have already funded to the extent of Rs.4.50 Cr., Bankers would be funding the balance.

Vinu

Let me tabulate that. Correct me if I am wrong!

Particulars

Rs. In Cr.

Working Capital Assets

9.25

  75% of WC Assets (9.25 x 75%)

6.94

Less: Funding already available from Creditors and Others

 (4.50)

Banking Funding available for WC

2.44

 

Manu

You are correct!

Vinu

So, I have a breather now. Out of Rs.4.75 Cr, Bankers will be funding Rs.2.44 Cr.

Manu

True. Now let us capture funds to be invested by you as Owner in the Working Capital of the Company:

Working Capital Funding required

4.75

Less: Credit available from Bankers

(2.44)

Funds to be invested by Owners in Working Capital

2.31

 

Vinu

It’s cool to hear. Investment in Working Capital has come down from the original level of Rs.4.50 Cr to Rs.2.31 Cr

Manu

Correct. But it is true, only when you ensure funds are arranged from other sources as we discussed (One month credit from Sundry Creditors and One Month Payment period for other expenses) Any set back from them would necessitate you to invest more.

Vinu

Got that! Now i have clear understanding of What is Working Capital Cycle and its Management. Thank you very much Manu. You made my day!

Manu

Glad that you appreciate the logics! Wishing you all the very best.

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