WORKING CAPITAL MANAGEMENT

Introduction: Working capital is the life blood and nerve centre of a business. Just as circulation of blood is essential in the human body for maintaining life, working capital is very essential to maintain the smooth running of a business. No business can run successfully with out an adequate amount of working capital.

Working capital refers to that part of firm¶s capital which is required for financing short term or current assets such as cash, marketable securities, debtors, and inventories. In other words working capital is the amount of funds necessary to cover the cost of operating the enterprise.

Meaning:

Working capital means the funds (i.e.; capital) available and used for day to day operations (i.e.; working) of an enterprise. It consists broadly of that portion of assets of a business which are used in or related to its current operations. It refers to funds which are used during an accounting period to generate a current income of a type which is consistent with major purpose of a firm existence.

Objectives of working capital:

Every business needs some amount of working capital. It is needed for following purposes-

‡ For the purchase of raw materials, components and spares. ‡ To pay wages and salaries. ‡ To incur day to day expenses and overhead costs such as fuel, power, and office expenses etc. ‡ To provide credit facilities to customers etc.

Factors that determine working capital:

The working capital requirement of a concern depend upon a large number of factors such as ? Size of business ? Nature of character of business. ? Seasonal variations working capital cycle ? Operating efficiency ? Profit level. ? Other factors.

Sources of working capital: The working capital requirements should be met both from short term as well as long term sources of funds.

? Financing of working capital through short term sources of funds has the benefits of lower cost and establishing close relationship with banks.

? Financing of working capital through long term sources provides the benefits of reduces risk and increases liquidity

Types of working capital:

Working capital an be divided into two categories-

Permanent working capital:

It refers to that minimum amount of investment in all current assets which is required at all times to carry out minimum level of business activities.

Temporary working capital:

The amount of such working capital keeps on fluctuating from time to time on the basis of business activities.

Advantages of working capital:

‡ It helps the business concern in maintaining the goodwill.

‡ It can arrange loans from banks and others on easy and favorable terms. ‡ It enables a concern to face business crisis in emergencies such as depression. ‡ It creates an environment of security, confidence, and over all efficiency in a business. ‡ It helps in maintaining solvency of the business.

Disadvantages of working capital:

‡ Rate of return on investments also fall with the shortage of working capital. ‡ Excess working capital may result into over all inefficiency in organization. ‡ Excess working capital means idle funds which earn no profits. ‡ Inadequate working capital can not pay its short term liabilities in time.

Management of working capital:

A firm must have adequate working capital, i.e.; as much as needed the firm. It should be neither excessive nor inadequate. Both situations are dangerous. Excessive working capital means the firm has idle funds which earn no profits for the firm. Inadequate working capital means the firm does not have sufficient funds for running its operations. It will be interesting to understand the relationship between working capital, risk and return. The basic objective of working capital management is to manage firms current assets and current liabilities in such a way that the satisfactory level of working capital is maintained, i.e.; neither inadequate nor excessive. Working capital some times is referred to as ³circulating capital´. Operating cycle can be said to be t the heart of the need for working capital. The flow begins with conversion of cash into raw materials which are, in turn transformed into work-in-progress and then to finished goods. With the sale finished goods turn into accounts receivable, presuming goods are sold as credit. Collection of receivables brings back the cycle to cash. The company has been effective in carrying working capital cycle with low working capital limits. It may also be observed that the PBT in absolute terms has been increasing as a year to year basis as could be seen from the above table although profit percentage turnover may be lower but in absolute terms it is increasing. In order to further increase profit margins, SSL can increase their margins by extending credit to good customers and also by paying the creditors in advance to get better rates.

WORKING CAPITAL AND RATIO ANALYSIS

Ratio Analysis is one of the important techniques that can be used to check the efficiency with which working capital is being managed by a firm. The most important ratios for working capital management are as follows

Net Working Capital:

There are two concepts of working capital namely gross working capital and net working capital. Net working capital is the difference between current assets and current liabilities. An analysis of the net working capital will be very help full for knowing the operational efficiency of the company. The following table provides the data relating to the net working capital of SSL.

NET WORKING CAPITAL = CURRENT ASSETS-CURRENT LIABILITIS

INFERENCE:

From the above table it can be inferred that the proportion of net working capital had increased from the year 2005 to2007 and decreed in the year 2008 compare with 2007.

Working capital turnover ratio:

This is also known as sales to working capital ratio and usually represented in times. This establishes the relationship of sales to net working capital. This ratio indicates -heather or not working capital has been effectively utilized in making sales. In case if a company can achieve higher volume of sales with relatively small amount of working capital, it is an indication of the operating efficiency of the company. It is calculated as follows-

YEAR NET SALES(RS) WORKING CAPITAL(RS) RATIO 2005 429128296 62214045 6.89 2006 622181610 120051813 5.2

2007 668215791 150379413 4.4 2008 655229319 145471893 4.5

INTERPRETATION:

From the above table we can conclude that working capital ratio is decreasing. In the year 2005 it is 6.89 times it decreased to 4.4 times in the year 2007. And it is increasing 4.5 times in the year 2008.

CURRENT ASSETS TO TOTAL ASSETS RATIO:

Current assets play an important role in day-to-day functioning of an organization. So, every firm should maintain adequate current assets so as to meet the daily requirements of business. If the proportion of current assets in total assets exceeds then the required limit, there will be some idle investments on such assets. At the time, the proportion of current assets in total should not less than requirements. So, every firm should maintain the adequate quantity of current assets. But during the situations of peak demand, should employ more current assets and vice-versa. Particularly in case of production organizations, there is heavy importance to the current assets than fixed assets. This kind of analysis will enable the managers to understand the working capital position of the firm. Data relating to the proportion of working capital in total assets is depicted as follows-

This ratio establishes the relationship between the current assets and total assets.

YEAR CURRENT ASSETS(RS) TOTAL ASSETS(RS) RATIO % 2005 217973661 390012770 55.88 2006 187602877 327640705 57.25 2007 169342603 475995664 35.57 2008 184541063 491935181 37.51

INFERENCE: From the above table it can be inferred that the proportion of current assets to total assets had decreased 55.88 in the year 2005. In the year 2005 it had increased to 57.25, again in the year 2007 it has decreased 35.57%, again in the year 2008 increase in 37.51 Current assets to sales ratio: The current assets are used for the purpose of generating sales. A ratio of current assets to sales reveals that how best the assets are applied in business for turnover. As per the above said ratio, a low proportion of current assets in relation to sales indicates better turnover of the company and vice-versa, which will show positive impact on profitability. The data relating to this aspect is provided as follows and it is calculated as follows.

YEAR CURRENT ASSETS(RS) NET SALES(RS) RATIO % 2005 246755108 429128296 57.5 2006 289394416 622181610 46.5 2007 337982290 668215791 50.5 2008 363445554 655229319 55.4

INFERENCE: From the above table it can be inferred that the proportion of current assets to sales had increased to 57.5% in the year 2005. In the year 2006 it had decreased 46.5%. In the years 2007 it had increased to 50.5% and in the year 2008 had increased 55.4%.

Current assets to fixed assets ratio:

Total assets in any business contain both fixed and current assets. For properly functioning of the organization in terms of production and marketing it is necessary to maintain a properly balance between them. If the proportion of fixed assets increases, it will be a negative impact on the firm¶s liquidity and if current assets increase, production increases and which causes impact on the demand for the product. In view of effective management of funds and to invest on both fixed and current assets, it is necessary to take the decision as soon as possible. Data relating to the ratio between current assets to fixed assets is depicted as follows.

YEAR CURRENT ASSETS(RS) FIXED ASSETS(RS) RATIO % 2005 246755108 167454219 14.13 2006 289394416 184597059 15.67 2007 337982290 138013376 24.4 2008 363445554 202084725 18.0

INFERENCE: From the above table it can be inferred that the proportion of current assets to fixed assets had decreased 14.13% in the year 2005. In the year 2006 it had increased to 15.67%. In the year 2007 it had increased 24.4%it had decrease in year 2008 in 18.0%.

Working Capital Management: Is the management of all aspects of both current assets and current liabilities, so as to minimize the risk of insolvency while maximizing return on assets.

The primary objective of working capital management is to ensure that sufficient cash is available to:
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meet day-to-day cash flow needs; pay wages and salaries when they fall due; pay creditors to ensure continued supplies of goods and services; pay government taxation and providers of capital â¼³ dividends; and ensure the long term survival of the business entity.

It is critical to understand that Profit is not Cash. A company can be very profitable but it can collapse simply because it has insufficient cash/liquidity to pay its relevant bill (as stated above). Always remember that any company⼌s liabilities are settled with cash and not by profit. Executive Summary
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Working capital (also known as net working capital) is a financial metric that measures a company¶s operating liquidity.

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Working capital is defined as current assets minus current liabilities. A positive position means that a company is able to support its day-to-day operations²i.e., to serve both maturing shortterm debt and upcoming operational expenses.

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One of the metric¶s shortcomings, however, is that current assets often cannot be liquidated in the short term. High working capital positions often indicate that there is too much money tied up in accounts receivable and inventory, rather than short-term liquidity.

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All companies should therefore focus on the tight management of working capital. Inventory, accounts receivable, andaccounts payable are of specific importance since they can be influenced most directly by operational management.

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Companies that improve their working capital management are able to free up cash and thus can, for example, reduce their dependence on outside funding, or finance additional growth projects.

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If done right, working capital management generates cash for growth together with streamlined processes along the value chain and lower costs. Introduction

Many companies still underestimate the importance of working capital management as a lever for freeing up cash from inventory,accounts receivable, and accounts payable. By effectively managing these components, companies can sharply reduce their dependence on outside funding and can use the released cash for further investments or acquisitions. This will not only lead to more financial flexibility, but also create value and have a strong impact on a company¶s enterprise value by reducing capital employed and thus increasing asset productivity. High working capital ratios often mean that too much money is tied up in receivables and inventories. Typically, the knee-jerk reaction to this problem is to apply the ³big squeeze´ by aggressively collecting receivables, ruthlessly delaying payments to suppliers and cutting inventories across the board. But that only attacks the symptoms of working capital issues, not the root causes. A more effective approach is to fundamentally rethink and streamline key processes across the value chain. This will not only free up cash but lead to significant cost reductions at the same time. NWC: Definition and Measurement Working capital, also referred to as net working capital (NWC), is an absolute measure of a company¶s current operative capital employed and is defined as: (Net) working capital = Current assets ± Current liabilities Current assets are assets which are expected to be sold or otherwise used within one fiscal year. Typically, current assets include cash, cash equivalents, accounts receivable, inventory, prepaid accounts which will be used within a year, and short-term investments. Current liabilities are considered as liabilities of the business that are to be settled in cash within the fiscal year. Current liabilities include accounts payable for goods, services or supplies, shortterm loans, long-term loans with maturity within one year, dividends and interest payable, or accrued liabilities such as accrued taxes. Working capital, on the one hand, can be seen as a metric for evaluating a company¶s operating liquidity. A positive working capital position indicates that a company can meet its short-term

obligations. On the other hand, a company¶s working capital position signals its operating efficiency. Comparably high working capital levels may indicate that too much money is tied up in the business. The most important positions for effective working capital management are inventory, accounts receivable, and accounts payable. Depending on the industry and business, prepayments received from customers and prepayments paid to suppliers may also play an important role in the company¶s cash flow. Excess cash and nonoperational items may be excluded from the calculation for better comparison. As a measure for effective working capital management, therefore, another more operational metric definition applies: (Operative) net working capital = Inventories + Receivables ± Payables ± Advances received + Advances made where: inventory is raw materials plus work in progress (WIP) plus finished goods; receivables are trade receivables; payables are non-interest-bearing trade payables; advances received are prepayments received from customers; advances made are prepayments paid to suppliers. When measuring the effectiveness of working capital management, relative metrics (for example, coverage) are generally applied. They have the advantage of higher resistance to growth, seasonality, and deviations in (cost of) sales. In addition to better comparison over time, they also allow better benchmarking of operating efficiency with internal or external peers. A frequently used measure for the effectiveness of working capital management is the socalled cash conversion cycle, or cash-to-cash cycle (CCC). It reflects the time (in days) it takes a

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company to get back one monetary unit spent in operations. The operative NWC positions are translated into ³days outstanding´²the number of days during which cash is bound in inventory and receivables or financed by the suppliers in accounts payable. It is defined as follows: CCC1 = DIO + DSO ± DPO where: days inventories outstanding (DIO) = (average inventories ÷ cumulative cost of sales) × 365 = average number of days that inventory is held;
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days sales outstanding (DSO) = (average receivables ÷ cumulative sales) × 365 = average number of days until a company is paid by its customers;

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days payables outstanding (DPO) = (average payables ÷ cumulative purchasing volume) × 365 = average number of days until a company pays its suppliers. Optimizing the three components of operative NWC simultaneously not only accelerates the CCC, but also goes hand in hand with further improvements. Figure 1 illustrates how an NWC optimization impacts the value added and free cash flow of a company. However, applying the right measures will not only increase value added by lowering capital employed. Improved processes will also lead to reduced costs and higher earnings before income and taxes (EBIT). Best-Practice Working Capital Fig 1

Holistic Approach to Working Capital Management By streamlining end-to-end processes, companies can, for example, reduce stock, decrease replenishment times from internal and external suppliers, and optimize cash-collection and payment cycles. The key is to uncover the underlying causes of excess operative working capital. In order to address the often hidden interdependencies among the different components and achieve maximum savings from a working capital program, companies must analyze the entire value chain, from product design to manufacturing, sales and after-sales support. They must also look for ways to simplify and streamline processes and eliminate waste, always keeping potential tradeoffs in mind. For instance, cutting inventories of spare parts or reducing product customization could lead to a major reduction in inventory. But how would these measures affect service quality, market positioning, or other aspects of the business? Managing the Three Operational Components of NWC So, what are the relevant levers of working capital management, and how are they applied? In effect, receivables and payables are just different ways of financing inventories. Companies need to manage all three components simultaneously across the value chain so as to drive fundamental

reductions in asset levels. Given the wide range of possible actions, focus is critical. A realistic plan with clear priorities is the best approach. An overly ambitious agenda can overstrain internal capabilities and deliver suboptimal results. Instead, companies should concentrate on the most promising actions that will not impair flexibility and performance. These actions will vary depending on industry and competitive situation, and have to be adapted to country specifics and regulations. In the following paragraphs some typical (but just exemplary) levers are described. Reduce Inventories Excess inventory is one of the most overlooked sources of cash, typically accounting for almost half of the savings from working capital optimization projects. By streamlining processes within the company²as well as processes involving suppliers and customers²companies can minimize inventory throughout the value chain. Enhanced forecast accuracy and demand planning: Improved forecast accuracy and regular updates of customer demand lead to a much more reliable planning process and help companies not only to reduce their inventory but also to improve the ability to deliver.
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Advanced delivery and logistics concepts: In order to keep inventories at lower levels, topperforming companies establish advanced and demand-driven logistics concepts with their suppliers, such as vendor-managed inventory, just in time (JIT) or just in sequence (JIS), and collaborate with their suppliers in terms of a holistic supply chain management with mutual benefits.

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Optimized production processes: An important lever to reduce work-in-progress inventory is the redesign of production processes. The main objectives here are to reduce non-value-adding time (³white-space reduction´) and excessive inventory between production steps. Promising measures are removing bottlenecks and migrating from push concepts to demand-driven pull systems.

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ervice level adjustments: An increased service level for products which are critical to the

customer (and thus allow higher prices) and a decreased service level for products which are uncritical to the customer will not only lead to optimized stocks. A more sophisticated approach

to calculating security stocks based on target availability and deviations in production and demand will also reduce out-of-stock situations for critical parts.
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Variance management: Reducing product complexity and carefully tracking demand of product variants in order to identify low-turning products is one way to reorganize and tighten the assortment and concentrate on the most important products. Moreover, where applicable, components should be standardized. Customization of products should take place as late in the process as possible. Speed Up Receivables Collection Many companies are early payers and late collectors²a formula for squandering working capital. Other companies²particularly project-based businesses and manufacturers of large, costly products with lengthy production cycles²have cash flow problems caused by a mismatch in timing between costs incurred and customer payments. Therefore, efficient management of receivables and prepayments received is crucial. An optimization can yield significant potential. Invoicing cycle: The main target in this respect is to get invoices to the customers as quickly as possible. Processes and systems should be aligned to allow invoicing promptly after dispatch or service provision. All disruptions of the process by unnecessary interfaces should be eliminated. Furthermore, companies should reduce invoicing lead times by multiplying their invoicing runs.

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Early reminders/dunning cycles: Experience shows that a number of customers seem to postpone their payments to the receipt of the first payment reminder. Early reminders and short dunning cycles thus have a direct impact on late payments. Best-in-class companies reduce grace periods to a minimum or remind their customers of upcoming payments even before the due date. Establishing direct debiting with main customers is the most effective means to avoid overdue payments.

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Payment terms: Renegotiated payment terms will lead to reduced DSO. The first step is often a harmonization and reduction of available conditions to decrease discretionary application. When preparing negotiations, companies should analyze their customers¶ bargaining power and specific preferences in order to identify improvement potential in the terms and conditions for payments.

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Payment schedule: Companies operating in project business should introduce more advantageous payment schemes that cover costs incurred. Percentage of completion (POC) accounting helps to define relevant payments along milestones. But also for companies with small series productions, the introduction of prepayments and advances can significantly improve liquidity. Rethink Payment Terms with Suppliers If fast-paying companies are at one end of the spectrum, then companies that ³lean on the trade´ and use unpaid payables as a source of financing are at the other. Between these two extremes there is a more effective, integrated approach to payment renegotiation that takes into account all aspects of the customer±supplier relationship, from price and payment terms to delivery time frames, product acceptance conditions, and international trade definitions. Payment cycle: Payment runs for payables should be limited to the required frequency. Here, of course, country- and industry-specific business conventions apply. Moderate adjustments of payment runs just require some changes in the accounting systems, and tend to be a ³quick hit.´

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Avoidance of early payments: Payments before the due date should be strictly avoided. Payments should be accomplished with the next payment run after the due date (ex post). Switching from ex ante to ex post payments is common practice and entails an easily implemented lever for increasing payables.

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Payment conditions: A DPO increase can often be achieved by renegotiating payment conditions with suppliers. Best-practiceapproach here is to first get an overview of all payment terms in use and to define a clear set of payment terms for the future. Renegotiations with suppliers are based on these new standard terms. It is critical to take into account supplier specifics. For those with liquidity constraints the focus should lie on prices, whereas for suppliers with high liquidity the payment term can often be extended.

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Product acceptance conditions: Connecting the settlement of payables to the fulfillment of all contractual obligations may result in significant postponements of respective payments. Enforcing supplier compliance to stipulated quality, quantity, anddelivery dates is also the basis for optimized, demand-oriented supply concepts. Prerequisite is full data transparency on relevant events.

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Back-to-back agreements: Balancing the due dates of receivables and payables helps to avoid excessive prefinancing of suppliers and can even lead to a positive cash balance. Mind the Tradeoffs Applying best practices of working capital management also means applying value-oriented management of tradeoffs between NWC and fixed assets, and between NWC and costs. The isolated treatment of individual levers has its boundaries and, therefore, all elements of tied-up capital across the balance sheet (fixed assets, inventories, receivables, payables, and cash) have to be considered as a whole. For example, it may be advantageous to acquire a new and more flexible machine (fixed asset) in order to reduce inventories. As another example, negotiations in purchasing cannot only focus on payment targets. The company also has to consider the resulting prices and discount conditions. Therefore, a best-practice NWC optimization is not just a pure reduction of NWC; it is rather a holistic optimization with value creation as the overarching target. est-Practice Working Capital Fig 2

Making It Happen Since working capital optimization affects many areas of a company, detailed planning and a holistic approach are crucial for the success of a project. The following points provide some success factors of implementation: How should we approach a working capital optimization project? A benchmarking for the company and for all segments/business units should be conducted in order to identify the most promising areas for improvement and respective units. Following this, the project should start with a few selected pilots. Once these pilots have been executed, knowledge gains can be transferred to other business units, and further projects can be rolled out to the entire company.
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How do we ensure that a working capital initiative is sustainable? There are four main aspects to successfully anchoring an NWC project into an organization and making it sustainable: 1.

Commitment and resources (sponsorship by top management, clear responsibilities, dedicated teams, internal experts as multipliers). 2. Communication and enabling (conveying motivation and necessity, fostering know-how exchange and best-practice sharing, providing training on NWC principles). 3. Incentives (inclusion in budget planning, linking variable salary to target achievements, recognizing jobs well done). 4. Controlling (integration into existing reporting formats, tracking target achievement and implementation progress).
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How long does it take to optimize NWC? In order to keep a momentum for change and to get a proof of concept, the right mix of quick wins and deep-dive improvements should be aimed for. Quick wins are usually realized within less than a year. They can make up roughly 30% of the overall potential. The overall sustainable optimization takes about three years, depending on company size and industry. According to project experience, the next 40% of the overall potential can be realized in the second year and the rest (about 30%) in the third year.