Understanding Working Capital Management

By

Dr. Sorab Sadri
Research Professor & Director
Rai Business School
Navi Mumbai
&
Dr. Sharukh N Tara
Senior Faculty in Finance and Governance
Allana Institute of Management Studies & Research, Mumbai
Visiting Faculty in Finance
Rai Business School, Navi Mumbai
 

As we move from HR Strategy to Strategic HR, there is a growing need felt that people managers of the future are going to be increasingly called upon to understand financial management, information technology and production systems. There is no denying this contention since every manager has to thrive on the cutting edge of global competition in the new world order and the WTO regime. And so his knowledge has to be well rounded. This short paper is based on the authors interaction with the management teacher's fraternity in India ever since 1991 and the experience based conviction that both accountancy and mathematics remains a chimera that the average HR Manager is only too happy to side step. It is a well-documented fact that as more and more senior managers are expected to be multi-skilled and multi-functional it has been observed that H R Managers are the ones usually left behind. They speak of benchmarking but seldom practice it themselves. They talk of funds management but there is invariably a blind spot about this in their mind's eye. Yet assessing the impact of HR interventions and also balancing the training budget needs at least a rudimentary knowledge of working capital management.

On the other hand going through some of the assignments submitted by students specialising in HR at the MBA level convinces me of their abject ignorance of Finance. How can these students ever go in for successful Strategic HR interventions in the corporate world remains a major worry for teachers like us? That is what got us thinking and hence this paper is addressed to these managers in waiting as well. To begin with let the HR Manager (in practice or in waiting) appreciate that the dark and dismal science of economics is certainly not dark neither is it dismal. It is fairly exact and very exciting provided the tools are in the hands of the right craftsman and the teacher knows his subject. We have always opined that people who are ill schooled in this fine subject should have sufficient self-respect and refrain from teaching it. The younger generation deserves this. We shall therefore begin with understanding some Economics (which we consider the jewel in the crown of social sciences) and move through common sense into one aspect of Financial Management (which is a specialisation we consider to be bedrock of all managerial sciences). In both instances mathematics is a language that the craftsman must understand and learn to use judiciously. From a teacher's viewpoint the author's advice to HR Managers (in practice and in waiting) is to get their theory right since once theory is perfected reality would be unable to hold out. Case studies are an excellent tool for teaching a subject provided the theory has been understood. If not, they degenerate into story telling sessions where the mouth starts to function long before the brain is engaged into gear. This paper merely attempts to simplify the theory behind working capital management for HR Managers in particular and non-Finance Managers in general.

Some basic definitions in Economics must first of all be understood.

* Production is the creation of value.
* Consumption is the destruction/conversion of the state of that value.
* Distribution is the process that links the above two.

Some basic premises of the Economic science also need to be cited

* All value is created by labour
* Capital is man made aid to production
* Investment is the process of capital creation.

So you cannot say "I am investing two years of my time and Rs 2 Lakhs as fees in getting an MBA Degree." What you are doing is making a financial outlay in the hope that the piece of paper (Diploma /Degree) that you get at the end of the two-year period can be traded for a job in the labour market. What you get by way of knowledge is abstract commodity and it can well be argued that both the teacher and the taught are partners in the expansion of knowledge. Machinery, goods in process, inventory and buildings on the other hand are capital. Money is not capital. In fact Crowther's famous poem is very helpful to recall at this stage.

Money is a matter of functions four,
A medium, a measure, a standard, a store.

So the question rises as to what is working capital? Imagine a four-legged table with a glass top. This is the euphemistic structure of working capital. The first leg symbolizes cash and bank balances, the second leg symbolizes Inventories, the third leg symbolizes Receivables and the fourth leg symbolizes Investments. The glass top symbolizes the allocation and utilization of scarce available resources so that corporate objectives are met. The tabletop made of brittle glass has to support some very heavy iron weights and to top it all there is a glass of whisky on it. The glass of whisky is stable so long as the four legs are equal and the top is even in surface. If any leg were to be longer than the rest or shorter than them the whisky would spill. If the table were weak and cannot support the weights then also the whole structure would collapse.

Let us assume that the glass top supports all this weight and in addition your wife brings a heavy steel dish full of grilled chicken. The dish is inordinately heavy so the glass top would shatter. Then you will surely lose the chicken, break the tabletop and more importantly waste the good whisky. To add it all you have to listen to your wife's admonishments.

Now replace the wife with the shareholders and the iron weights with your short-term liabilities. The dish of chicken with additional business you never expected but now has to be financed and which the four legs which stand for your assets would have to support. The glass of whisky is replaced with profits. Now very simply, putting the right weight, having a balanced table and enjoying your whisky and chicken in peace is what working capital management amounts to.  Keeping the wife pleased is a bonus.

In short, it boils down to the management of funds in the short term as opposed to managing long-term capital such as shares and debentures.

The HR Manager must appreciate that short-term capital has to be repaid within a short period such as a year so its management is volatile. Working capital is after all the sum total of current assets, which are used to pay back current liabilities and generate profits. The goal of proper working management is to see that the current assets and current liabilities are maintained in such a way that a satisfactory level of working capital is maintained. It relates to funds in the short term or a period normally one year and it is always transformed from cash into other assets and back into cash within a business cycle.

Now let us see what the cash we need has to do with the normal operating time often called the process cycle time. Some types of businesses may have a longer operating cycle and this could be well more than a year or even a decade as in the case of distilleries. Other businesses may have a short operating cycle as a fast food store.

If at a point of time the organisation does not have sufficient funds to meet its short-term debts such as creditors and salaries as well as day-to-day expenses it may become technically insolvent.  On the other hand, if it is very conservative it will have a surplus of working capital, which will adversely affect profits. So it is easy to appreciate that the ratio of fixed assets to current assets is a good measure of the balance to be maintained.

There is no specific thumb rule.  It varies from industry to industry and the nature of business. Some industry norms are given below.

Proportion of current assets to fixed assets

INDUSTRY                                PROPORTION
HOTELS                              10-20%
ELECTRITY DISTRIBUTION      20-30%
ALUMINIUM & SHIPPING         30-40%
IRON STEEL & CHEMICALS      40-50%
COTTON TEXTILES                60-70%
TRADING                             80-90%

The ideal mix thus depends on the nature of the industry. Now we shall very briefly take each component of working capital and see what are the best practises adopted by industry in managing them.

Inventory is one of the most important components of working capital and its proper management cannot be under stressed. Fundamentally, inventory consists of raw material, work in progress and finished goods. The proportion of inventories to fixed assets is quite high ranging from 25% to 45% in the manufacturing sector (in cement it is around 25%). Hence inventory management is crucial for all managers irrespective of functional specialization. Since a number of industrial relations disputes in manufacturing industries are linked to production bonus and incentives relating to inventory irrespective of the market need for inventory, the HR Manager must understand this point well. Every member of the organization feels its impact and yet scant respect is paid to it. This is most unfortunate. A serious study of sick companies will support this contention. Hence those managers who are involved with Strategic HR should take note of some of these important criteria for insuring proper management.

1. Maintaining a proper level of stock
2. ABC analysis to control high value items more intensively as compared to low value items.
3. Proper ordering policies.
4. Pricing of raw material work in progress and finished goods.
5. Control over wastage and obsolescence.

Further research by industrial economists sheds light on some practises adopted by various industries, which are shown through extracts from their balance sheets. Let us quickly glance at some of these important indicators.

Accounts receivable :  This also forms an important part of working capital and depends on the credit policy adopted by the firm namely

1. How much credit to be given
2. For how long is it given
3. Discounts for early payment
4. Collection and recovery efforts

Cash management: This as mentioned is the most liquid of all assets and is required to

1. Meet day to day expenses
2. As a hedge against uncertainties.

Too much cash is not good nor is having too little a healthy practice. Good companies usually have a practise to plant surplus cash in risk free securities or inter company deposits. On the other hand, companies with a deficit tend to borrow at a high rate of interest indicating a lack of planning. A sudden surge in business may spur the need of working capital and this may also require additional interest to be paid and again planning is important.

The key to all management and especially working capital management is to plan your work and then work to your plan. This also is an important aspect of working capital management and good companies have the practise of planning their needs well in advance.

Here is piece of advice to all those colleagues within the HR fraternity. The next time your wife makes chicken and you invite your colleagues over to your house for dinner and drinks, please remember that this is all about working capital management. If they have a fun time you are a damned good manager. If someone drops the glass or breaks your table or slips and breaks his head then you know what to think of your self.
 

Dr. Sorab Sadri
Research Professor & Director
Rai Business School
Navi Mumbai
&
Dr. Sharukh N Tara
Senior Faculty in Finance and Governance
Allana Institute of Management Studies & Research, Mumbai
Visiting Faculty in Finance
Rai Business School, Navi Mumbai
 

Source: E-mail March 25, 2006

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