Working Capital Management

Introduction

Overview of the course

Pipeline theory of working capital: Accounts receivable capture major working funds of an enterprise. Hence the trade credit policy should be such as to increase the value of the business, without endangering it. Inventory management has come to major focus in working capital management of an enterprise. While the risk of being out of stock is very high in the production floor and the marketing outlets, overstocking eats into the profitability of an enterprise both in terms of cost of funds and wastage of materials. Models like MRP shall be dealt with. Cash flow framework and the day to day management of liquidity models shall be discussed. Management of current liabilities shall be discussed. Financing working capital requirement shall be discussed.

Definition
Accountants view: Current Assets Current Liabilities. Concerned at the arithmetical accuracy. Finance Managers view: Current Assets. Concern is to find funds for each item of CA at such cost and risk that the evolving financial structure remains balanced. Production Controllers View: the fund needed to meet the day to day working expenses ie. to pay for materials, wages and other operating expenses. A more expressive definition: the amount of capital required for the smooth and uninterrupted functioning of the normal business operations of a company ranging from the procurement of raw materials, converting the same into finished products for sale and realizing cash along with profits from the accounts receivables that arises from the sale of finished goods on credit. Gross WC: total of CA including loans and advances. Net WC: CA CL including provisions.

Definition contd
An alternate way of looking at working capital is Non cash working capital defined as: Non cash current assets non interest bearing current liabilities. Why cash is removed from the definition?
Although cash is often held to cover the day to day operations of the firm, it is also held for other reasons like future investments, safety buffer against adverse circumstances etc. Cash earns a market interest rate and hence there is no opportunity cost unlike inventory and accounts receivables. ( AR) Only cash that should be considered for the narrower definition of WC is the cash required for day to day operations. With the advancement of cash management technologies the cash required for day to day operations has also become smaller. The CMS services of banks enables companies to lower interest costs by reducing the transit time of cheques, improves liquidity, better accounting and reconciliation etc.

Systems approach operating cycle method

The two sub systems are productive system and the distributive system of a manufacturing concern. Productive system is defined as the means by which resource-inputs are transformed into utility products and services. A distributive system is defined as the means by which such utility products are distributed to consumers. The process by which inputs are transformed into outputs is called conversion process. A finance manager has to take an integrated view of the whole system for proper management of working capital.

Productive system
Let us assume that the conversion process has 3 sequential stages S1, S2 & S3 taking 6 hrs, 4 hrs & 8 hrs. In order to minimize the idle time the line has to be balanced. A simple approach to balance the line is taking LCM of 6, 4 & 8 which is 2. hence S1 will have 3 work places, S2 will have 2 & S3 will have 4. The balanced conversion will generate 12 units every day with a cycle time of 2 hrs. There will be 9 units of inputs always in the pipe line.
6 hrs 6 hrs 6 hrs 4 hrs 4 hrs 8 hrs 8 hrs 8 hrs 8 hrs

Distributive system
The process is assumed to be continuous and the flow of finished goods from the conversion process is 12 units/day. Assumptions to devise a distribution system: Also, assume that the sales are on 30 days credit basis. Hence, pipeline inventory = 228+360 units. ( 30*12) = 588 units. This includes FG+ debtors. Adding 9 units of WIP, the total inventory = 597.
Sequences Average time in days 1 1 5 5 2 3 1 1 19 Average pipeline inventory 12 12 60 60 24 36 12 12 228

Factory storage Factory to warehouse Processing delay at warehouse Warehouse to distributor Processing delay with distributor Distributor to retailer Handling and processing at retailer Retailer to consumer Total

In order to enable the system to produce continuously, the pipeline inventory of 597 units cannot be reduced. Apart from the pipeline, inventories are also built up for:
Optimizing cost and usage of funds, ensuring a reasonable liquidity etc

Two types of inventories that get build up are:

Cycle inventories: the operators in the productive distributive process does not order for inventory as and when necessary but follows a cyclical replenishment method based on review of demand and inventory status, transmission time etc. Buffer inventories: besides cycle inventories, a firm is also required to hold additional inventories to absorb random fluctuations in consumer demand. This is called buffer inventory. This can be estimated based on various probabilistic models to cushion the effect of greater than expected demand and the average demand during the supply lead time.

All these put together forms the minimum possible inventory levels. The inventories might be higher if the system is not efficient. A small rise or fall in the tail end of the system can create strain on the firms resources. The strain may be more severe for firms like Bata India which has to fund the entire system as a whole as it is wholly owned.

Other discreet assets:

Besides funds blocked in physical inventories, the system may generate other discrete assets like cash. The liquid cash is necessary as a cushion against sudden lengthening of the pipeline or a rise in its intensity due to demand. Other examples includes, security deposit with statutory authorities, suppliers, advance payments etc. OC theory does not capture the other discreet assets as these are not in the pipeline.

Assigning Monetary values

S1 RM OME S2 Value from S1 OME S3 Value from S2 OME COP Distribution Value from conversion Admin & Distribution COGS 10 2 12 4 16 8 24 24 1 25

Techno financial approach

Core Working Capital: if the pipeline were to stop at the conclusion of the production process ie if all goods released by the production cycle were to get sold immediately in cash, the firm would have required working capital only for the conversion process. This is called CWC. In our present example: Annual production is 4320 ( 12*360) COP Rs 24 * 4320 = 103680 COS = Rs 25*4320 = 108000 Operating expenses are divided under variable and fixed expenses. The former is proportional to the volume and the later is a period cost. Allocation of OH can be made based on the fund cycle of the production process. The amount of variable working expenses and hence the fund engaged in the conversion process is the value of the WIP. The conversion fund cycle = aggregate COP / WIP at any point of time. In the given example = 103680 / 164 = 632.2 times. Ie velocity of conversion fund is 632.2 times a year. Unit velocity of conversion = 1/632.2 = 0.00158179. Total OH in the example is Rs 4320. Hence, the OH allocated to each cycle of conversion fund = 0.00158179*4320 = 6.83. Hence, total fund blocked in conversion cycle = 164+6.83 = 170.83. This is the minimum fund the firm requires under ideal conditions termed as CWC.

Techno financial approach

Unit velocity of CWC is dependent upon given technology and operating condition. Hence it should remain stable for a reasonably long period of time. A finance manager can do very little on the CWC multipliers of WIP. But there is scope for a finance manager to reduce the multiplier along the distribution line.

Projection of WC
If the volume gets doubled from 4320 to 8640, the variable expenses will also get doubled to 207360. Conversion fund cycle = 0.00158179*207360 = 328. OH per cycle = 0.00158179*4320 = 6.83. ( FOH remain the same) CWC = 328+6.83 = 334.83. This is same as COS * Unit velocity. Both pipeline and discrete assets blocks certain number of CWC cycles. In order to find out the number of CWC cycles blocked by each asset, divide the amount blocked by the asset / CWC. Ex: WIP/CWC will give the number of cycles blocked by WIP.

Tracing cash
Cash = LTD + Equity+ CL CA other than cash - FA Sources and uses of cash:
Increasing LT debt & decreasing LT debt Increasing equity & repurchasing some stock Increasing CL & paying off a 90 day loan Decreasing CA other than cash & buying some inventory by cash Decreasing FA. & buying some property

Why did Chrysler offer zero interest loans for low mileage products in 2006 when the gasoline prices soared? What was the impact on the inventory days of its gas guzzlers?

Operating & Cash cycles

Day Activity Cash effect

Acquire inventory

None

30

Pay for inventory

(1000)

60

Sell inventory on credit

None

105

Collect on sale

1400

Operating & Cash cycles

Operating cycle:
The time we acquire inventory to the time we collect cash ie 105 days. The first part is the time to acquire inventory and sell the same ie 60 days. This is called the inventory period The second is the time to collect on sale ie 45 days called the AR period. Operating cycle = inventory period + AR period. At each step the asset is moving closer to cash.

Cash cycle:
The cash flows and the other events that occur are not synchronized. For the AP period we dont pay for the inventory and we dont collect until 105 days. Hence, 105 -30 = cash cycle. We have to arrange financing for this period. Cash cycle = operating cycle AP period. The gap in CF can be filled either by ST borrowing or by holding a liquidity reserve in the form of cash or marketable securities. This can be shortened by managing the inventory, AP and AR periods.

Operating & Cash cycles

Example of managing the cash cycle: Amazon
In mid 2006 the market value of Amazon was more than 6 times that of the brick & mortar bookseller Barnes & Noble even though the sales were only 1.7 times greater. ST management is one major factor in this. Amazon turned its inventory about 30 times a year which was 5 times faster than B&N. Amazon charges its customers CC when it ships and gets paid from the CC firm in a day. It had a negative cash cycle of 56 days. Similarly Boeing had an inventory period of 59 days and receivables period of 49 days. So its operating cycle was 108 days. But its payables period was 208 days and hence the cash cycle was (100 days).

Calculating the operating and cash cycles

Item Inventory AR AP Net sales COGS Beginning 2000 1600 750 Ending 3000 2000 1000 Average 2500 1800 875 11500 8200

Calculating the operating and cash cycles

Inventory TOR = COGS / Average inventory = 8200/2500 = 3.28 times This means that inventory was bought and sold off 3.28 times during the year. Inventory period = 365 days/ ITOR = 111.3 days. Ie inventory sat for 111.3 days before it was sold. Receivables TO = credit sales / Average AR = 6.4 times Receivables period = 365/ ARTOR =57 days. Ie the customers took an average of 57 days to pay. Operating cycle = 111.3 days+57 days = 168 days. Ie it takes 168 days for the inventory to get converted to cash. APTOR = COGS/ average AP = 9.4 times AP period = 365 days/9.4 = 39 days. Cash cycle = 168 39 = 129 days.

Interpreting the cash cycle

Cash cycle increases as the inventory and receivables period gets longer It becomes shorter if the company can defer the payment of payables. The longer the cash cycle the more the financing requirement. A lengthening of the cash cycle is an early warning signal that the firm is having trouble moving its inventory or collecting its receivables. Such problems can be masked at least partially by an increased payables cycle. Hence both should be monitored.

Short term financing policy

The size of the firms investment in CA: a flexible or accommodative policy will maintain a high ratio of CA/ Sales. A restrictive policy would maintain a low CA/Sales ratio. The financing of CA: a flexible policy means low ST debt / Long term debt ratio. A restrictive policy means high ST debt / low LT debt. Hence a firm with a flexible policy will have relatively large investment in CA which is financed through LT debt. Flexible policy includes actions like:
Keeping large cash and marketable securities balances Making large investments in inventory Granting liberal credit terms which results in large AR.

Restrictive policy actions includes:

Low cash balances Small investments in inventory Few credit sales.

Short term financing policy

Managing CA can be thought of as involving a trade off between costs that rise and costs that fall with the level of investments. Costs that rise with increases in the level of investments in CA are called carrying costs. The larger a firm makes investments in CA, the larger the carrying costs. Costs that fall with the increases in the level of investments in CA are called shortage costs. In general carrying costs are the opportunity costs associated with investments in CA. the rate of return in CA is very low when compared to the firms required rate of return. Shortage costs occur when a firm runs out of cash, runs out of inventory or when it is unable to extend credit to its customers. A flexible policy is most appropriate when carrying cost is low when compared to shortage cost. A restrictive policy is most appropriate when carrying costs are high relative to shortage costs.