Understanding Working Capital

[Equity Section]

Net Current Assets and Working Capital are one and the same thing. We know that Working Capital is the difference of Current Assets and Current Liabilities. Current Assets include Inventories, Sundry Debtors, Cash & Bank Balances and Loans & Advances. Current Liabilities include Liabilities and Provisions.

To understand Working Capital dynamics, let us assume that a certain company has a Working Capital of 10 crores. With that 10 crores, the company buys raw materials worth Rs. 10 crores from a supplier for the production in its plants. Now, the company pays the supplier 5 crores and gets a credit period for 60 days for the rest 5 crores. Hence, the company registers 10 crores as raw material Inventory. The rest of the Rs. 5 crores which is to be paid to the suppliers is taken as Liabilities.

Now, the company processes that 10 crores of raw material as finished products in its plants. The final value of the finished products comes out to be Rs. 30 crores. Now, the company is able to sell its products worth Rs. 25 crores. The remaining products worth Rs. 5 crores will again get into the Inventory as finished products.

Out of the 25 crores worth of products which were sold, the company gets Rs. 20 crores as Cash. The rest Rs. 5 crores get stuck with the customers as the company is giving them some credit term of, say, 30 days and it is termed as Sundry Debtors.

Out of that 20 crores which the company recieves as Cash, Rs. 5 crores goes to Loans & Advannces as the company might be giving some loan to a corporate entity or it might be giving some advance for some licence or an advance salary to its employees, and that this money will get returned to the company either in cash or in kind. Now the Cash Component stays out to be Rs. 15 crores after that payment.

Now, this 15 crores is free Cash with the company. With this Cash, it can either quickly pay out the Liability of Rs. 5 crores to the suppliers easily. Also, the company can Provision out a certain portion of Cash as dividends to the shareholders.

So, this is the way in which that Rs. 10 crores of Working Capital gets distributed over Current Assets and Current Liabilities. Thats why their understanding is so important to the understanding of the dynamics and payment terms of a particular business.

[Equity Section]

We'll be using again Hawkins Cookers to understand the dynamics of Working Capital. This is the link to their Annual Report. On page 14 is the Balance Sheet.
equitysection.proboards.com/index.cgi?action=downloadattachmentpage&board=fundamentalanalysis&thread=5&post=9

Hawkins Cookers has a Net Current Assets or Working Capital of Rs. 48.55 crores. Practically, this is the capital with which this company buys raw materials from suppliers and sells their products to customers.

With Rs. 48.55 crores, they buy certain amount of raw materials, of which Rs. 50.55 crores is yet to be paid to the suppliers, meaning the supplier gave them a certain credit period. They have an overall Current Liability of Rs. 54.81 crores. You can see the breakdown of Current Liabilities by scrolling down a few pages on Page 19 at Schedule 12.

From the raw materials they bought, Rs. 16.14 crores of raw materials is still in Inventory alongwith other items like Packing materials, tools etc., as has been explained by Schedule 8 on page 18. Total Inventory is Rs. 38.77 crores.

Of the finished products this company produced from the bought raw materials, Rs. 4.65 crores is still in inventory as Finished Goods, meaning it hasn't been sold and Rs. 16.85 crores of goods is still under the process of manufacturing, as has been explained by Schedule 8.

As we can see that Hawkins Cookers did a Net Sales of Rs. 331.54 crores and a Net Profit of Rs. 31.76 crores from the Profit & Loss Statement. This Sales happened only because of the Working Capital of Rs. 48.55 crores. Out of the Rs. 31.76 crores of Net Profit, Rs. 39.10 crores is Sundry Debtors amount meaning that amount which is yet to be received from the customers, meaning the company is giving its customers credit period of some duration, as seen from Schedule 9 on Page 18.

At the same time, Hawkins Cookers has Cash & Bank Balance of Rs. 46.75 crores which comes directly from Sales as being paid by the customers, as specified by Schedule 10. Some portion of cash might also be from past retained earnings. Also, their Loans & Avances, the amount which'll be returned to Hawkins Cooker either in cash or in kind, is Rs. 5.70 crores.

Now, if we can remember that Hawkins Cookers has a Current Liability of Rs. 54.81 crores and that amount can only be paid by the earnings i.e. Net Profit amount. We know that Hawkins Cookers has Sundry Debtors of Rs. 39.10 crores. When this money'll come to the company, they'll be able to pay their suppliers along with the Cash & Bank Balances amount. Thats why, to be in a comfortable position, the company shall always try to bring money quickly from their Sundry Debtors or customers so that they can pay their Current Liabilities or suppliers.

This shows the importance of Working Capital in the dynamics of business. Since, business is done for cash, money shall come quickly from the customers or Sundry Debtors. Money shalln't get stuck with them for a long time. At the same time, company shall always look for credit periods from their suppliers or Current Liabilities to have a comfortable time duration during which they can bring in the cash from their customers and also to have a comfortable cash position to meet some unforeseen exigencies.

[Equity Section]

One important tool to help us better understand the dynamics of Working Capital is Cash Conversion Cycle (CCC).

Cash Conversion Cycle (CCC) tells us about the time duration taken by the Cash during which -

1. it leaves the Company to pay for Account Payables due to purchase of raw material Inventory,

2. then, returns back after Sales happen and payment received from Account Receivables / Sundry Debtors

It indicates as to how efficiently the working capital is being managed, meaning, whether the company is able to get longer credit periods from its suppliers and is able to quickly draw in money from its customers.

Cash Conversion Cycle has three components - Days Inventory Outstanding, Days Sales Outstanding and Days Payable Outstanding.

1. Days Inventory Outstanding (DIO) indicates the number of days in which the inventory is getting totally consumed. The smaller the number of days, the better it is for the company. If a company is showing higher DIO over previous years, it can mean that either the company is purchasing large amounts of raw materials as Inventory or the company's order books have either got cancelled or dried up, because of which the Inventory is lying idle.

DIO can be calculated as

DIO = Average inventory/COGS per day
Average Inventory = (beginning inventory + ending inventory)/2

COGS means Cost of Goods Sold. Here, Cost of goods sold includes both cost of raw materials from which products are made and Purchase of Traded Goods. Both, Cost of Goods Sold & Purchase of Traded Goods amounts can be found on the Profit & Loss Statement.

Beginning Inventory means Inventory figure for the previous year. Ending Inventory means Inventory figure for the current year, taking into consideration that the statements are annual. If the quarterly figures're available, then beginning inventory will be for the just previous quarter and ending inventory will be for the current quarter.

2. Days Sales Outstanding (DSO) indicates the number of days taken for the amount to be received from the sales proceedings to the company's customers. Again, the lesser the number of days, the better it is. If a company's DSO is increasing over previous years, it can indicate either reducing sales or reduced public appeal/branding power.

DSO can be calculated by using

DSO = Average Account Receivables (AR) / Revenue per day
Average AR= (beginning AR + ending AR)/2

Account Receivables (AR) is simply Sundry Debtors i.e. the amount that is yet to be received from the company's customers or clients.

Revenue is Net Sales.

Beginning AR is the AR for the prior period while Ending AR is AR for the ending period.

3. Days Payable Outstanding (DPO) indicates the number of days taken by the company to pay its suppliers or Sundry Creditors. Here, the longer the duration of days, the better it is. Because, the company will have comfortable liquidity condition and will have ample time to bring in money generated from its business operations from their Sundry Debtors to pay their suppliers or Sundry Creditors. If DPO is decreasing over previous years, it can indicate that either there's some sort of trust deficit on supplier's side or the supplier is giving substantial discounts to the company to pay in advance for the raw materials.

DPO can be calculated by

DPO = Average Account Payable (AP) / COGS per day
Average AP = (beginning AP + ending AP)/2

Account Payable (AP) is simply Current Liabilities.

Beginning AP is AP for the prior period, while Ending AP is AP for the current period.

Now,

CCC = DIO + DSO - DPO

This CCC figure will tell us the number of days within which the Cash leaves the company to pay its suppliers for Inventory and then comes back after the Inventory gets converted into Sales which further gets converted into Sundry Debtors. The shorter the CCC, the better the liquidity position of a company.

Now, three situations can happen.

Situation 1 : Company gets some definite credit period from their suppliers i.e. DPO, say 60 days. Company consumes their Inventory, say within 30 days i.e. DIO. And post Sales, company receives money from Sundry Debtors/Account Receivables after, say 45 days i.e. DSO. So, here, Cash will have to leave company on the 60th day to pay for its Account Payables and will return on DIO + DSO i.e. 30 + 45 = 75th day. That means Cash will leave the Company for 15 days. This 15 days will be the CCC here.

Situation 2 : Suppose DPO is 60 days. DIO is 15 days and DSO is 5 days. Now here, Cash has to leave the company on the 60th day. But, already Company generates money from the business done with Inventory on credit period and also receives money on DIO + DSO = 20th day. The company still has 40 days not to pay its supplier. This means that CCC is -40 days. Here, practically, the company even doesn't need Cash to run business. Its doing business with the credit being provided by the suppliers or Account Payables. Any company will like to be in this model where you earn money before you pay.

Situation 3 : Suppose DPO is 0 days. DIO is 30 days & DSO is 15 days. Here we see, Company has to pay for its raw materials in advance. Means, Cash leaves the Company to pay in advance on the 1st day itself. While it comes back on the DIO + DSO = 45th day. Here, Company needs it own Cash to run its operations.

[Equity Section]

We'll be again using Hawkins Cookers Annual Report for the understanding of Cash Conversion Cycle practically, the link for which is provided below.
equitysection.proboards.com/index.cgi?action=downloadattachmentpage&board=fundamentalanalysis&thread=5&post=9

As we know Cash Conversion Cycle has three components - Days Inventory Outstanding, Days Sales Outstanding and Days Payable Outstanding.

1. Days Inventory Outstanding (DIO) indicates the number of days in which the inventory is getting totally consumed. The smaller the number of days, the better it is for the company. DIO can be calculated as

DIO = Average inventory/COGS per day
Average Inventory = (beginning inventory + ending inventory)/2

So,

Average Inventory (in crores) = (31.15 + 38.77)/2
= 34.96

COGS is Materials under Expenditure heading in Profit & Loss Statement on Page 15.

So,

COGS (in crores) per day = 136.73 / 365
= 0.37

Now,

DIO = 34.96 / 0.37
= 94.48 days

This states that Hawkins Cookers Inventory gets consumed in 94.48 days.

2. Days Sales Outstanding (DSO) indicates the number of days taken by the company to receive the amount from the sales proceedings to the company's customers. Again, the lesser the number of days, the better it is. DSO can be calculated by using

DSO = Average Account Receivables (AR) / Revenue per day
Average AR= (beginning AR + ending AR)/2

Average AR (in crores) = (28.03 + 39.09) / 2
= 33.56

Revenue is Net Sales from Operations. Income from other Sources should be excluded. The figure can be found on Profit & Loss Statement.

Revenue (in crores) per day = 331.54 / 365
= 0.90

DSO = 33.56 / 0.90
= 37.28 days

So, Hawkins Cookers takes 37.28 days to receive money from its customers.

3. Days Payable Outstanding (DPO) indicates the number of days taken by the company to pay its suppliers or Sundry Creditors. Here, the longer the duration of days, the better it is. Because, the company will have comfortable liquidity condition and will have ample time to bring in money generated by its business operations from their Sundry Debtors to pay their suppliers or Sundry Creditors. DPO can be calculated by

DPO = Average Account Payable (AP) / COGS per day
Average AP = (beginning AP + ending AP)/2

Average AP (in crores) = (42.24 + 54.81) / 2
= 48.53

COGS (in crores) per day = 0.37 as calculated above

DPO = 48.53 / 0.37
= 131.14 days

So, Hawkins Cookers is able to have credit period from its suppliers for 131.14 days.

Now,

CCC = DIO + DSO - DPO
= 94.48 + 37.28 - 131.14
= 0.62 days

This demonstrates that Hawkins Cookers gets a credit period for 131.14 days meaning it doesn't need to pay anything to its suppliers for that time-period. In the meantime, Hawkins Cookers consumes the inventory , processes it, sells it and gets back the money from its customers within 94.48 + 37.28 = 131.76 days. So, actually, the Cash leaves the company to pay the suppliers on 131.14th day and comes back on 131.76th day. This indicates that the Cash leaves Hawkins Cookers for 0.62 days and returns back doing business.

This is what Cash Conversion Cycle tell us. This CCC figure and also the individual components figure can be use for comparisons over previous years to gauge the efficiency of business.