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Efficiency matters

Murali Iyer

With steady reports of excellent quarterly results for December 1999, one may be tempted to wonder whether the economy has really started to pull out of its tailspin. But a closer look reveals that the results are good not because of better realisations or higher volumes but from effectively managing working capital.

This particular section in a balance sheet says a lot about the state of a company's finances at a time when falling demand growth, rising input costs and scarcity of capital, have come together to put corporate profitability under tremendous pressure.

The topline (sales) might have grown for a company, but the bottomline (net profit) could have been weighed down by various factors like rising inventory levels, higher receivables, resulting in more borrowings, and hence, higher interest payments. The stock market will give a thumbs-down for such a performance, as much of the higher revenue could be parked in receivables.

This would indicate that the company could have thrust goods down dealers' throats to show higher sales. On the other hand, even if a company manages a flat topline (or in some cases a negative topline growth), but manages its working capital better to finish with a higher bottomline, the stock is likely to seek higher levels. This is the economics of the stock market.

Basics of working capital
What is working capital and how is it calculated? This is the most common question that would pop up in someone's mind. The basic reason for a company's existence is to make a profit. For a product to be sold to make a profit, certain inputs are needed to first make it. Once a product is sold, the proceeds are re-invested into the company to make further products, and make more profits. Herein lies a problem.

When a product is produced and sold, ideally the cash against the sale should be received immediately. This doesn't happen in the real world. There is a time lag between the time that the goods are sold and realising profits. If a company waits till this money comes in for it to be re-invested and goods are produced again, the entire plant and machinery could be prone to lying idle for long durations. Thus, to ensure smooth operations through this time lag, each company earmarks funds. This is known as working capital for that business entity.

Where is it used?
Working capital is required by a business entity in a variety of places. It is used to maintain inventories of raw materials, spares and stores, and also finished as well as semi-finished goods. It finances credit sales (better known as receivables), cash in the bank and in the hand, and also short-term loans and advances. The latter category could be to employees, franchisees, dealers etc. All these are called current assets and can be converted into cash during a financial year. Together, they comprise the gross working capital of a business entity and are shown on the assets side of a balance sheet.

Current assets are generally set-off or financed through current liabilities. This consists of trade creditors, advance payments, unclaimed dividends and provisions for various things like taxes, dividends, pension, gratuity etc. Current liabilities also mature within the same financial year - just like current assets.

The difference between the current assets and the current liabilities is the net working capital required by that business entity. Whatever is left after setting off the current assets against the current liabilities is met out of short-term credit from banks and financial institutions. The security offered for such financing is generally inventories and guarantees.

Importance to shareholders
From a shareholder's point of view, the most important aspect is the effective management of working capital by a company. Prudent and effective management of working capital becomes necessary as neither does it come free nor does it come cheap. There is an opportunity cost attached to management of working capital besides the inevitable interest burden that comes on back of short-term bank borrowings.

The cost of working capital can be especially high during times of economic slowdowns as inventories and receivables would rise, bloating the current assets considerably. But importantly, current liabilities would refuse to keep pace with current assets, as creditors would shy away in such cases. With a wide gap building up between current assets and current liabilities, it becomes more expensive to finance working capital, and the result is a huge hit on the profitability.

Piling receivables and inventories also provide another problem to the company - that of affected cash flows. Large cash outflows like dividends and interest payments are liable to get affected due to a fall in cash inflows. A lot of companies finance these shortfalls by way of long-term loans, which again puts the company in a tight spot, as funds for financing its expansion plans would have been utilised for such activities. This puts further pressure on the balance sheet.

Commodity companies (petrochemicals, chemicals, textiles, steel etc) are capital intensive. Thus, they require high working capital. Being cyclical in nature, their business puts additional pressure on the working capital when the going is tough. On the other hand, industries like hotels are also cyclical in nature; their fortunes are linked to the economic scenario. Although they generate cash on a regular basis, the receivables are prone to get high during a recession and the topline can also be under pressure. Thus both commodity-based companies as well as hotel stocks are unable to extract a higher valuation in the stock markets.

What do you look out for?
A steadily declining working capital turnover ratio is the first indicator of trouble in a company - trouble in effectively managing its working capital. This ratio is calculated by dividing the net sales by net working capital. It shows the number of times a company is able to churn its working capital to generate revenues. Higher the ratio, the better is the company's ability to manage its receivables, inventory and cash so that it can generate more revenues from it.

Companies that effectively manage their working capital better have a high ratio. Companies with low working capital requirement or those that keep their working capital on the low side have a high ratio.

But, the stock market attaches a premium to companies that have a low requirement of working capital, as they are less liable to get trapped in a morass even during an emergency. A company with a high working capital turnover ratio vis-a-vis peers ends up getting a higher valuation or a better price-earnings ratio.

So, look out for those companies that generate higher revenues from a limited working capital, as eventually they will be more profitable, with better cash flows. As they say: when the going gets tough, the tough get going. But not managing working capital effectively will get the company in a position to justify what a smart aleck in the National Defence Academy at Khadakvasala came up with: when the going gets tough, the tough report sick!

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