Why Working Capital Management Isn’t As Scarier As You Thought It Would Be
Conversation between Manu and Vinu about working captial management.
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?
Manu: Then please assign value for each and every item.
Manu: So, your balance sheet should be looking like this:
Manu: So now with this investment, your Factory is ready.
Manu: With this you can start the production.
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
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.
Manu: We stopped, when customer is ready to place order. Is that 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.
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:
- Your sales order was Rs.5.00 Cr.
- Let’s say these sales would take place every month.
- So your annual sales should be Rs.5 Cr x 12 months = Rs.60 Crs
- Your raw material cost is Rs.3 Cr x 12 months = Rs.36 Crs
- Your others costs were Rs.1.50 Cr x 12 months = Rs.18 Crs
- Your profit is Sales (60 Crs) – Cost (54 Crs) = Rs.6 Crs
- You may have to keep one month raw material as stock – Rs.3 Crs
- 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.
- You have to keep the finished goods for one month – So its value is Rs.4.50 Cr.
- 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.
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.
Manu: So now, you appreciate that regular funding support required is for Rs.13 Crs only and not Rs.17.50 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.13.00 Cr
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.
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!
Manu: Look at the difference!
Vinu: Wow…That’s significant drop from Rs.13 Crs to Rs.4.75 Crs. Whopping Rs.8.25 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:
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.
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!
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:
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.