How much secure is providing working capital (WC) finance against the current assets of a company?

Indian banks generally provide working capital fund based and non fund based facilities to companies against the security of first pari passu charge on the current assets of the company and second pari passu charge on the fixed assets of the company. When the company (the borrowing entity) is doing well then everything goes well. The company submits at the end of every month closing stock (i.e details of inventories, work in progress, and finished goods) and receivables position along with the details of creditors. The fund based limits are increased or reduced based on this closing stock & receivables position within the capped WC limit. There is no amortization schedule for repayment of working capital facility. The non fund (Letter of Credit, Bank Guarantees etc.) facility continues on rolling over basis. The WC facility is generally sanctioned as one year line i.e. at the end of one year the bank has right to close the limit. However mostly banks roll over the lines in good times. When the things go bad, it becomes a tricky situation because the profitability and credibility of the company is affected and it is not in a position to replace/repay an existing working capital bank if the same is demanded by the lender.  When the things gets worsened leading to winding up of the borrower, the working capital banker faces a complicated situation since by that time borrower would have sold its entire finished goods, the unpaid creditors would have taken back the stocks supplied by them, there would be hardly any stock under process, the stockyard of at the factory would be empty not having any raw material, the company would have already liquidated all the possible receivables. This is a very peculiar situation when there is hardly anything left to the working capital banker of which he/she can take charge for sale off and repayment of working capital finance.  The only hope left to him is any residual funds which may be available when the first charge holder banks liquidate the fixed assets of the company. However, it is common experience that generally the realizations from fixed assets are not sufficient enough even to fully repay the dues of first charge holders.

Therefore, considering working capital finance provided against the security of current assets as safe lending would not be prudent.

How to calculate the Operating Cycle for a manufacturing firm?

Well, you can calculate the Operating Cycle as following:

(a) Raw Material Storage Period

(i) Calculate the cost involved in annual consumption of raw materials

(ii) Calculate average daily consumption of raw materials by dividing (i) by 360 days

(iii) Calculate average stocks of raw materials as following:

(Raw material at the beginning of the year + Raw material at the end of the year) divide by 2

(iv) Divide average stocks of raw material by daily average consumption i.e. (iii) divide by (ii) resulting in no. of days of raw material storage say X1 days.

(b) Work in Progress (WIP) Period (also called Conversion Period)

(i) Calculate annual cost of production : Take opening WIP + consumption of raw materials during the year + other manufacturing cost like salaries, electricity bills etc. + depreciation – closing WIP

(ii) Calculate average daily cost of production by dividing (i) by 360 days

(iii) Calculate average stock of WIP as following: 

(WIP at the beginning of the year + WIP at the end of the year) divide by 2

(iv) Divide average stock of WIP by average daily consumption of WIP i.e. (iii) divide by (ii) resulting in no. of days of raw material storage say X2 days.

(c) Finished Goods (FG) Storage Period

(i) Calculate annual cost of sales : Opening stock of FG + cost of production as calculated above at b(i) + Excise Duty payments + Selling Cost + General Administrative Cost + any Finance Cost -  Closing stock of FG

(ii) Calculate average daily cost of sales by dividing (i) by 360 days

(iii) Calculate average stock of FG:

(FG at the beginning of the year + FG at the end of the year) divide by 2

(iv) Divide average stock of FG by average daily cost of sales i.e. (iii) divide by (ii) resulting in no. of days of FG storage say X3 days.

(d) Average Collection Period

(i) Calculate credit sales during the year

(ii) Calculate average daily credit sales by dividing (i) by 360 days

(iii) Calculate average balance of Debtors (also called Sundry Debtors)

(Sundry Debtors at the beginning of the year + Sundry Debtors at the end of the year) divide by 2

(iv) Divide average Sundry Debtors by average daily Sundry Debtors i.e. (iii) divide by (ii) resulting in no. of days of Average Collection Period say X4 days.

(e) Average Payment Period

(i) Calculate annual credit purchases

(ii) Calculate average daily credit purchases by dividing (i) by 360 days

(iii) Calculate average balance of Creditors (also called Sundry Creditors)

(Sundry Creditors at the beginning of the year + Sundry Creditors at the end of the year) divide by 2

(iv) Divide average Sundry Creditors by average daily Sundry Creditors i.e. (iii) divide by (ii) resulting in no. of days of Average Payment Period say X5 days.

Now calculate the Operating Cycle as following:

Gross Operating Cycle in days: X1 + X2 + X3 + X4 = Say G1 days

Net Operating Cycle in days :  G1 days – X5 days

You will appreciate from the all the components are basically the Levers of Working Capital. The better a firm manages each of the Lever the better control of the firm will have on its Working Capital. A firm may plan its policy on each no. of days for each of the above component and monitor from time to time. Any deviation from the policy Standards will lead to scrutiny in order to take remedial actions. 

How to control Working Capital for the business?

The control of Working Capital depends on the nature of the business. If someone asks how much time a city Bus will take to reach from place ‘X’ to place ‘Y’ (say distance between two places is 100 Kilometre(Km) and the average speed of the Bus is 50 Km per Hour, there are five Stops and at each Stop Bus stops for 10 minutes), you will simply calculate the total time required for covering the distance which is 2 Hours (Distance divide by Speed) and add 50 minutes of stoppage time, working out to total time of 2 Hours and 50 Minutes.

Similarly, in business also, the total amount of Working Capital money requires to calculate the total no. of days (remember the ‘distance’ for the Bus) money has to stay trapped in various forms (relax I will explain).

In a simple Grocery Shop business:

 -> You buy Stocks (i.e convert the Cash form into Stocks form; if you buy some Stocks from Vendor on credit basis then you also create Credit form which is required to be converted into Cash form later at the time of payment to Vendor),

-> Sale grocery items on credit to your customers (convert Stocks form into Debtors form),

-> Collect money from your Debtors (convert Debtors form into Cash form),

-> Pay to your Vendors for the credit availed (convert Credit form into Cash form)

What do you observe from the above? It is simply a cycle into which money gets converted in to various forms during the business process and at the last converts back into the form of Cash. This cycle is called the Operating Cycle.

In a manufacturing firm, Cash is used to purchase Raw Materials (RM) (purchased by paying in Cash which is rare or on credit terms thereby creating Creditors), RM is then processed and converted from one intermediate product form to another intermediate product form (called as Work in Progress) before taking the final shape of Finished product, Products are sold on credit (creating Debtors), payments are collected from Debtors and payments are also made to Creditors. The chain can be reflected as following:

Cash and Creditors (credit period says 5 days) - > RM (say 10 days) - > Work in Progress (say 6 days) - > Finished Products (say 4 days) - > Debtors (say 3 days) - > Cash net of payment to Creditors

=10 + 6 + 4 + 3 = 23 days (This is Called Gross Operating Cycle)

From the above, you need to deduct the 5 days credit period provided by the Supplier or Vendor because this is period for which there was no actual cash of manufacturing firm got trapped in the cycle, so:

 = 23 – 5 = 18 days (This is called Net Operating Cycle)

The control of Working Capital depends on the net no. of days money gets trapped into each of the above stages.

So, in order to control the Working Capital of the business, you first need to calculate the Operating Cycle.

Are there different types of Working Capital?

When you start a grocery shop business, you invest money (initial capital) for procuring the grocery items. If the business runs successfully, you keep on increasing the stock (but from which sources?). You increase the stocks by ploughing back the profits earned, by keeping the initial capital in the business or by increasing the initial capital (i.e. putting more money). You will need to maintain a minimum level of Stocks in the Shop (i.e. keeping minimum level of money invested in the Current Assets) in order to run the business at minimum level. Therefore, this money can be called the Permanent Working Capital.

Depending on the business needs, you will be increasing the Current Assets (over and above the minimum required level) or reducing the Current Assets (but not reducing below the minimum required level). This increase or decrease in Current Assets will involve increase or decrease in money invested in Current Assets and called the Variable Working Capital.

What’s more important: Gross Working Capital or Net Working Capital?

I feel both the concepts have their own importance.

When you invest in Current Assets you consider the return or profit by increasing the money invested in Current Assets. If increase in Current Assets does not improve your return (i.e. by increase in profits generated by your business) off course you would be reluctant in investing in Current Assets. Here, you do not look at Gross or net Working Capital. Therefore, it is more of the business economics which depends on the rate of return from business and focuses on total Current Assets or Gross Working Capital.

The Net Working Capital has more relevance to your banker and your accountant. What happens if Current Assets are less than the Current Liabilities? It means even by selling the entire Currents Assets, your business will not be able to pay off its bank loans (availed for purchasing the Stocks) or pay off to your Vendors (who have supplied goods to you on credit terms). The difference between Current Assets and Current Liabilities reflects your business’s liquidity position or the solvency. It is therefore this net Working Capital concept which is more important to your creditors than the Gross Working Capital.

Theoretical View on Working Capital

After explaining Working Capital in simplified way above, I would also like to touch upon the academic important view on Working Capital. Can we question why should one invest in Working Capital? The answer lies in objective of maintaining the Working Capital. When you increase Current Assets in the business, it off course provides comfort in maintaining the business (the more and varied Stocks you have, the more customers will drop in because they get wider choice and surety of getting the item at your Shop, isn’t it?). However, increasing the Current Assets involve cost. It does not come free. You have to either invest more from your own pocket in the business OR borrow from banks OR negotiate with your Vendors for more credit terms (in terms of volume as well period) for supply of Stocks. When you invest in the business from your own pocket, you expect profit (at a rate at least more than the interest rate offered by banks on fixed deports (FD) i.e. if bank offer 10% p.a. on FD for 1 year, you expect return from business more much more than 10% p.a. otherwise what’s the benefit of taking such big risk on your money!). Any guarantee for earning profit (more than 10% p.a. on your investment)? If no, than better to invest money in Bank FDs or other avenues than to invest in increasing Current Assets in business.

When the Vendor gives you one month credit, he will sell the goods to you at x% more than the selling price he will agree if you purchase in cash. Why? Because Vendor is indirectly giving you money (in the form of goods) for one month which he bought by borrowing from his banker at say 10% p.a. After all he has to recover interest what he needs to pay to his banker. So, if USD 100 is the cost of goods if purchase in cash, then on one month credit basis term, the Vendor will sell the same goods to you at USD 100.83 (USD 100 plus USD (100 X 10%)/12). Therefore, the more money you invest (by own source, borrowing, credit terms), the more money you will need to return to your financiers and your profitability will come down.

The objective of Working Capital management is to maintain or better say balance the liquidity and profitability depending on the your attitude towards risk in the business under constraints imposed by the environment (condition of creditors, bankers etc.)

What is Working Capital?

In plain words if I define Working Capital I would like to say that it is the essential capital for running the business and importance of which can be compared with importance of blood required for functioning of our body.

Let me explain. Think that you have decided to start business of grocery shop. You have only USD 100,000 in Cash. You purchase a fully furnished ready for business shop with USD 100,000 at an attractive location where you have analysed that it will be convenient for the people to drop in and make purchase for their day to day needs.

Note: With purchase of shop you have converted your Cash Asset into a Fixed Asset.

Before you commence your business, you need to fill the shop with various grocery items. Based on your procurement list, it requires USD 80,000 for purchasing all these items. Further, you also require USD 5,000 for your day to day Cash needs for running the shop.

You have only USD 50,000 in your account i.e. you are short of USD 30,000 for purchasing the required Stock and USD 5000 for meeting your day to day needs (i.e. total short fall USD 35,000). You speak to the wholesale grocery Vendor and tell him about your Cash shortfall problem.  He agrees to give you credit equivalent 20% of your total purchase (i.e. USD 80,000) which works out to USD 16,000 for 1 month credit period i.e. you have to pay him USD 16000 at the end of 1 month from the date of purchase. Even with this arrangement, You are still short of USD 19000 (i.e. USD 80,000 plus USD 5000 minus USD 50000 minus USD 16000). 

Note : (1) You converted Cash USD 50000 into Grocery items worth USD 80,000. (2) You created a short term (i.e. 1 month) liability in the form of Unpaid Creditor.

You speak to your Banker for lending you USD 19000, and the Banker happily agrees to lend you USD 19000 at the rate of interest of 10%  p.a. for 1 year period provided you give him security of grocery Stock which will be lying in your shop.

Note : You created Short Term liability in the form of Debt of USD 19000. This Cash you use for 1. Payment of USD 14000 to Vendor 2. Keep Cash in business USD 5000.

With the above arrangement in place your Shop starts on January 01. Let’s say by January 31, you have sold 90% of the item with 25% profit margin.

On January 31, you have the following requirements:

A1. Payment of unpaid USD 16000 to grocery Vendor

A2. Interest Payment of USD 158.33 to Bank

A3. Shops electricity bill payment USD 500

A4. Your fixed remuneration USD 500

A5. New grocery Stock purchase requirement of USD 72000

Total payment requirement (sum 1 to 5): USD 89158.33

By selling the grocery items during the month, you have generated following Cash:

B1. Sales in Cash (90% of the total Stock): USD 72000

B2.  Add profit on Sales (25% of the Sales): USD 18000

Total Cash generated: USD 90,000

Note : Don’t’ forget that you have another USD 5000 as Cash in business for meeting day to day needs.

You use this Cash as following:

C1. Payment of items A1 to A4 i.e. : USD 17158.33

C2. You discuss with your Vendor to continue the relationship of 1 month Credit and he also happily agrees since you have fulfilled your promise by Cash payment at the end of the month, so you pay him 80% of your fresh purchase requirement (item A5 above) i.e. : USD 57600

Total Cash Payment: USD  74758.33

Cash left with you: USD 90,000 plus USD 5000 minus USD 74758.33 equal to USD 20241.67

From all the above management and work of 1 month, at the end January 31, your Shop business has following it owns and owes:

1. Cash: USD 20241.67 (Shop’s Current Asset) (Remember that apart from profit this Cash also includes USD 5000 for meeting day to day business needs)

2. Old Stock: USD 8000 (remember you had sold only 90% of the total Stock of USD 80,000 !) (Shop’s Current Asset)

3. New Stock purchased: USD 72,000 (Shop’s Current Asset)

4. Shop with value of: USD 1,00,000 (Shop’s Fixed Asset)

4. Short Term Debt (Bank Loan): USD 19000 (Shop’s Current Liability)

5. Unpaid Creditor: USD 14400 (Shop’s Current Liability)

7. Money the Business Owes to You (remember your Cash investment of USD 1,00,000 plus USD 50,000) : USD 1,50,000 (Shop’s Long Term Liability)

8. Your profit generated from 1 month’s successful operations: USD 16841.67 (Shop’s Long Term Liability)

Total Current Assets: USD 1,00,241.67

Total Fixed Assets: USD 1,00,000

Total Assets: USD 200241.67

Total Current Liabilities: USD 33400

Total Long Term Liabilities: USD 150000

Total Long Term Liabilities (Retention of Profits): USD 16841.67

Total Liability: USD 200241.67

From the above, you will be amazed with some of items named as Current Assets, Current Liabilities, Fixed Assets, and Long Term Liabilities. What are these jargons? If you analyze the nature of these items, you can simply, conclude as following:

Current Assets: Simply the grocery items lying in the Shop which can be converted in to Cash at any point of time (So you can say at least within time period of one year), and the Cash maintained by the Shop.

Current Liability: Unpaid Vendor and Debt from Bank to be repaid shortly (here also you can say within maximum time limit of 1 year. Remember the loan period stipulated by your Banker, 1 year!)

Fixed Asset: Assets procured on permanent basis which cannot be sold by business for generating the regular sales. But these assets are required as basic block/foundation being critical for business. Remember, the first thing you required for the Business: ‘Shop’ the foundation. You will not be selling the Shop for generating the sales. Sales will come from selling the grocery items.

Long Term Liability: You will notice that these are liabilities that business does not need to repay immediately or in near future (You can say repayable at least after 1 year. Are you going to withdraw your investment of USD 1,50,000 plus your profit immediately? Off course not, unless you plan to close the Business by selling it to someone else!

So, from the above what are critical items for business to handle by putting heart and soul? Definitely it is the current/immediate needs of the Business. And what are these current needs? Off course the current assets and current liabilities which the business need to address immediately because Business cannot 1. afford to be short of grocery items (i.e. Current Assets) otherwise customer will be diverted to competitors if they don’t get the needed items at your Shop 2. Displease the Vendor by not making payments on time or defaulting to the Banker, otherwise the Vendor may not allow supply on credit basis or Banker may withdraw the loan.

How you have handled this criticality? See are what your Currents Assets and how did you procure them?

Your Current Assets: USD 100241.67 (comprises Stocks and Cash)

Your Current Liabilities: USD 33400 (comprises unpaid Vendor USD 14,400, Bank Loan for Stocks USD 14,000 and Bank Loan for meeting day to day Cash need USD 5000)

Difference: USD 66841.67 (How this gap is funded? From your Long Term Investment in the business for procurement of Stock: USD 50,000 plus your Cash profit of USD 16241.67 kept in the system)

From the above, you will appreciate that Stocks and Cash is something very critical to run your Shop. If no Stock and Cash, Shop cannot function! So, it is this capital required for maintaining the Current Assets which is must for running the business i.e. the capital of USD 100241.67 which is called as Gross Working Capital.

The difference between Current Assets and Current Liabilities (i.e. USD 66841.67) is called Net Working Capital or Net Current Assets.