Cash_Working_Capital_vs_Balance_Sheet_Working_Capital__an_Analysis_Based_on_Four_Cases

Cash Working Capital vs Balance Sheet Working Capital: An Analysis Based on Four Cases Author(s): S. K. Chakraborty Source: Economic and Political Weekly, Vol. 9, No. 10 (Mar. 9, 1974), pp. M11+M13+M15M17+M19-M22 Published by: Economic and Political Weekly Stable URL: http://www.jstor.org/stable/4363469 Accessed: 18/07/2010 23:36 Your use of the JSTOR archive indicates your acceptance of JSTOR's Terms and Conditions of Use, available at http://www.jstor.org/page/info/about/policies/terms.jsp. JSTOR's Terms and Conditions of Use provides, in part, that unless you have obtained prior permission, you may not download an entire issue of a journal or multiple copies of articles, and you may use content in the JSTOR archive only for your personal, non-commercial use. Please contact the publisher regarding any further use of this work. Publisher contact information may be obtained at http://www.jstor.org/action/showPublisher'publisherCode=epw. Each copy of any part of a JSTOR transmission must contain the same copyright notice that appears on the screen or printed page of such transmission. JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range of content in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new forms of scholarship. For more information about JSTOR, please contact support@jstor.org. Economic and Political Weekly is collaborating with JSTOR to digitize, preserve and extend access to Economic and Political Weekly. http://www.jstor.org Cash Working Capital Working vs Capital Balance Sheet An Analysis Based on Four Cases S K Chakraborty The conventional definition of working capital adopts a balance sheet view of resources for'sustain. ing the current operationsof the firm. However, the balancesheet is a static position statement of the firm on a certain date. It fails to indicate the dynamicflow of values occurring in the firm throughout a period. income or profit and The real dynamics of the pressureson cash flows are contained in the firnm's inflows and outflows of values-cash or credit loss statement. This statement contains all the operational -during a period. The operatingcycle concept of working capital a'iscussedhere is basically a profit and loss accountbased tool. I Working Capital in Common Parlance definition of workTHE conyentional of offsetting the ing capital in terms current claims against the firm against the curr'ent claims of the firm seems somewhat confusing. The surplus left after such offsetting is in fact equivalent to a portion of the long-term claims the against firm. One has only to visualise, the Balance Sheet layout to appreciate this point. Working Capital so dlefined is thus really a part of longterm finance used to support current activities-. This is the working capital margini money which is treated as fixed investment for project appraisals. The following simple illustration will make the point clear: trade creditors the current assets, less current liabilities (including bank overdraft) calculation would simply leave working capital at its previous figure. Liquidation of debtors and inventory into cash would also leave the working capital level unchanged. And so would payment of current liabilities in cash. Similarly, a relatively large amount of working capital according to this definition may produce a false sense of security at a time wrhen cash resouirces may be negligible, or wvhen these may be provided increasingly by long-term fund sources in the absence of adequate profits. Three points seem to emerge from above. First, the Balance Sheet definition of working capital is perhaps not meaningful, except for indicating the firm's current solvency in repaying its creditors. Second, when firms speak of Period 1 Period 2 shortage of working capital, they in fact (Rs) (Rs) Sales 1,000 1,500 imply scarcity of cash resources. ThirdWorkIng Capital ly, in fut:ds flow analyses increase in say, 34 of sales 250 375. working capital, as conventionally Constituted as defined, represents emnployment or Cnrrent Assets 350 525 application of ftunds. Conceptually, a Less, Cturrent Liabilities 100_ rise in working capital is thus at par _150 250 Nwith increase in, say, fixed assets or. an 375 Financed' by repayment of loans. With the cash Bank 'Overdraft definition of wvorkingcapital, however, (70 per' cent) 175 262 it is difficult to see how an increase:in L-ong-Term' cash is an application of funds. There Finance 75 113 seems, therefore, to exist the need for 250 375 a more direct and relevant measure of Thtis larger the amount of working cash working capital needs. capital so *derived, greater the proporThe Balance Sheet is a static position of kIng-term capital soutrces siphontion statement of the firm on a certain ecl off to short-term activities. It is date. It fails to indicate the dynamic (litficult to say whether -this is right or flow of values occurring in the firm not. Apparently, when firms are worried throughout a period. These value flows abllut tigyht working capital situation, in a going concern centre mainly around the logic of the above definition would the operational activities of the business perhaps indicate diversion of long-term in any period. For a manufacturing finances for short-term purposes. For, concern these operations are related to if bank overdraft were substituted for procurement of materials, their conver- sion, sale of finished goods and realisation of debtors. Part of material and labour resources may be used Qn credit terms. Similarly, sales could be partly in cash and the rest on credit. In the ultimate analysis, however, it is cash flows which will keep the firm going in the long-term. Creditors and debtors and similar items are merely transient stopgaps. The firm will keep itself working and solvent so long as cash flows are not undutilyupset. And the real dynamlics of the pressures on cash flows are contained in the firm's Income or Profit and Loss Statement. This statement (or account) contains all the operational inflows and outflows of values cash or credit - during a period. The conventional definition of working capital adopts a Balance Sheet view of resources for stustainingcurrent operations. The operating cycle concept- to be developed below is, however,; basically a Profit and Loss Account-based tool. II Operating Cycle Concept If we shift away from the Balance Sheet (lefinition of working capital, we have to focus attention on the Income Statement and on the cash version of working capital. The transition to this vantage point is achieved, t-hrough the operating cvcle concept (OG.%- In doing so, however, the Bala,6e`.Sheet is not completely cast aside.t. '.As we ' shall examine below, the 641~ulationof the OC period in itself actsg'as a link between the Balance Sheet- and the Income Statem t. Underlying the application'if Qf:h - O concept is a more functionalM interpretation'" of the role of working capital. It is argued here that the basic function of working capital is to support all opera-tional activities of the firm, and costs thereof, M-11 ECONOMIC AND POLITICAL WEEKLY over a period. It is only a part of this function to be able to meet the current liabilities as and when these fall due. The cash version of working capital fits appropriately in this wider perspective.' The systematic exposition of the OC concept is contained in Park and Gladson's work.2 The main thrust of their work has been in using the OC period for a business to define its current liabilities and current assets. This definition, quite logically, is suggested as a finer criterion to judge the funds flow pattern through working capital items, than the conventional one-year timespan. Calculation of the OC period by following through the successive stages of committing cash in the operations and finally getting it back into the stream again to l)egin another cycle, is quite tailor-made to the individual characteristics of a firm. All specific technological as wvell as commercial features of an enterprise are provided with a sharper analytical focus while deriving the duration of the OC. Thus, the nature, age, and mix of technical processes employed in a firm shall be the dominant influence on the conversion period of manufacture. credit Similarly, the periocl allowed to and by the firm for purchases and sales will determine the of materials length acquisition and storage and debtors' collection periods. In all these phases, the firm will have its owvn specific strengths and/or weaknesses, quite apart from some general intra-industry uniformities. It is such specificities which get highlighted in the OC period. Having derived the OC period for a firm, those items of assets or liabilities alone which liquidate themselves into or l)y cash within that period are classified as 'current' ones. Working capital computed from such items will be very different - Review of Management March 1974 will go opening w i p, materials consurned and all manufacturing expenses including wages, less closing w i p. The manufacturing expenses may have to be unearthed from schedules attached to the Profit and Loss Account. The pace of the conversion process is determined largely by the state of technological efficiency and supervisory abilities in the firm. The degree of completion of workin-progress on the opening and closing dates wvill influence the number of days for this phase of the operating below with cycle. This is illustrated simple figures where the same quantities of opening and closing w ip's are assumed 50 per cenit and 25 p-er cent complete, for the first period, and for the second period 25 per cent and 50 per cent complete, respectively. Year 1 Year 2 current asset items are subjective assessments flowing from accrual income accoLnting, the OC approach to cash forecasting (as demonstrated later) should provide a stronger focus on the key resource of cash.4 Another point should be mentioned here. The concept of cash working capital is being employed for the four case studies below to indicate cash needed for manufacturing and selling operations only. Cash outlays involving capital expenditures, dividend payments, etc, are being ignored. III Computation of Operating Cycle Period In the study presented below the following methodology has been used in determining the length of the operating cycle period. The calculations are all based on published account figures. In all cases we shall be dealing with manufacturing concerns. (Instead of taking 365 days in each year as below, it may be more realistic to assume a figure between 250 and 330 working days a year.) (1) Materials in Storage Period: This measures the average time bought, items remain in store prior to being released into the production stream. The following steps are involved in calculating it. (a) Materials consumed during the year, say, M. (b) Average daily rate of materials consumption, M/365. (c) Average materials inventory during the year, i e, (opening inventory + closing inventory)/ 2, say, I. (d) - Ntumber of days materials remain in store = I/(M/365). Materials consumed during the year could be readily found out with the help of opening and closing stock and raw materials purchase figures. (2) Conver&sion Process Period: This measures the time taken on average to carry out the basic manufacturing processes, converting material inputs into finished goods. The steps involved are: (a) Cost of finished goods production during the year, say, C. (b) Average daily cost of finished goods produced = C/365. (c) Average work-in-process during the year i e, (opening w i p + closing w i p)/2, say W. (d) * Average conversion time = W/(C/365). Into cost of finished goods produced Opening w i p Manufacturing expenses Closing v i p Cost of finished goods produced .- Conversion period 100 600 700 50 650 50 600_ 650 100 550 75z: 5 i e, 42 days * 365 75-: 5 * 365 i e, 50 days This difference of 8 days reflects the relative efficiencies of conversion in the two years. (3) Fintished Goodlsin Storage Period: Some time usually elapses before finished goods move ouit of the manufacturers' warehouse to the customer. This is particularly so for firms which produice for stock and not against orders. How speedily this movement takes place depends upon the nature of the product(s), market(s), the season of the year, the effectiveness of sales and muarketing tactics, etc. Calculation of this period follows the sequence given below: Cost of finished goocls sold during the year, say, F.. (b) Average daily cost of finished goods sold = F/365. (c) Average finished goods inventory during the year ie, (open-ing stock finished goods + c10s-ing stock of finished goods)/2,. say, G, (a) (d) .. Average period duLring which! finished goods remain in warehotuse = G/(F/365). and more relevant - from the one based on items classified as current on a one-year basis. It is surely more ulsefutl for a firm to know how soon a unit of money put into operation is going to be recouped again in cash for use in a fresh cycle of operations. The OC period indicates precisely this time-interval. In other words, the OC concept has a built-in stress on the cash interpretation of working capital for ongoing operations. Thus, Sagan's 'money manager' could gainfully use the OC tool as one means to escape the (liscomfiture of being presented with "a satisfactory working capital ratio when he does not have funds to meet an immediately due payment".3 Since many of the valuation bases adopted for Cost of finished goods sold during' the year is obtained by adding to cost of finished goods producedl in the year M-1-3. ECONOMIC AND POLITICAL WEEKLY [already calculated in 2(a) above], the opening stock of finished goods and all administrative and selling expenses, and deducting the closing stock of finished goods at the end of the year. The splitting of administrative expenses into manufacturing and selling expense categories has been regarded as not being practically very meaningful in this context. It is also assumed that finished goods inventory valuation is done on full cost or absorption cost basis. Review of Management March 1974 (4) Debtors' Coll.ection Period: Depeniding on the commercial conventions of trade for an industry in varying economic environments, and also on the firm's ownla credlit policies, the conversion of debtors into cash (stage 3 above being that of conversion of finishedl goods into debtors) will consume somne timte. Since published accounts (lo not usually show the break-up of sales into credit and cash categories, we shiall assumlle for our purposes all sales to be on credit. The calculation then is as below: (a) Average daily sales during the year, i e, (total net sales during the year/365), say, S. (b) Average debtors' balance during the year, i e (opening balance + closing balance)/2, say, D. (c) .-. Average collection period of debtor's balance = D/S. Since excise duty is payable by the firm on its sales, which is later on recovered from customers, two alternatives are possible. Either sales net of excise duty vbe considered, in which case the excise duty amount should be excluded in compuiting cost of goods sold. Or, gross sales valtue including excise duty be taken, in which case the duty amount should be adcded to cost of goods sold. There will be some variation in both the finished goods in storage and debtors' collection periods according to the particular alternative adopted. tion. Although depreciation is a noncash charge, yet it goes into the valuation of work-in-progress because of the absorption-costing basis assumed earlier. But since this is an expense not requiring cash outlay, we are excluding it in computing operational expenses. Other administrative and selling expenses are included. Taxes and dividends are not considered however in computing operational expenses because these are appropriations subsequent to IV the accrual of profits from operations. Four Cases These outlays are not meant for supportAs already mentioned, the analysis ing the operations of the business. The reported below is intended to demon- next step is to divide the total operastrate the use of the OC concept based tional expenditure for each year calcuon published annual reports of the firms. lated above, by the number of operatIn this section the analysis alone will ing cycles for the relevant year already be presented. The next section will figured out in step two earlier. The on an ex draw attention towards some of the resultant amount indicates highlights and limitations of the analy- post basis the cash workitngcapital that should have been required sis done here. to sustain The study covers four companies over the year's operations. This figure will a five-year period from 1965 to 1969. in all probability not equal the average These companies are Union Carbide of working capital amount as conventionIndia Ltd, Hindustan Lever Ltd, Dun- ally derived from Balance Sheet items lop (India) Ltd, and Guest, Keen and of opening and closing cumrent assets Williams Ltd. The first and the third and current liabilities. Let us examine firms belong mainly to the consumer Table 1. The follow^ing points emerging fromdurable goods industry. The second is a consumer goods producing firm. Table 1 are significant: The fourth one is in the producers' (1) The year 1967 seems to be the. goods industry. Published final accounts 'hump' year for nearly all phases of the for all these firms for the 5-year period operating cycle. This is reflected in the longest OC period provided all data used below. 159.5 days In each case the length of the OC - in that year during the 5-year period period has been computed for each of covered. And following from this, the the five years. This, in turn, has been number of OC's completed in 1967 is converted into the number of operat- also the least, i e, 2.5 approximately. ing cycles completed by each unit of The years 1968 and 1969 have registermoney in a year. In the third step we ed consistent reductions in all the first the firm, and to that extent is to be offset against the sub-total of the first four phases of the operating cycle period. Thus taking together the above five calculations, the operating cycle period is derived as follows: I/(M/365) + W/(C+365) + G/(F/.365) + D/S - C/P = OC. have computed from the Profit and Loss Accounts the total operational expenses on account of materials, wages, etc, for each year, excluding depreciaTABLE 1: UNION four phases of the OC. The credit period allowed to suppliers has, however, shown a slight rise in 1969 over 1968. Consequently, the O*C duration (INDIA) LIMITE.n CARBIDE Years Particulars Raw materials in store Conversion period Finished goods in store Debtors' collection period Less (5) Creditors'payment period (6) Operating cycle period (1) (2) (3) (4) (7) Number of operating cycles per year (365 " Row 6) (8) Cash wvorkingcapital requirement (9) Average working capital as per balance sheet 1965 Days 134.4 18.5 31.5 24.4 208.8 58.7 150.1 2.431 Rs/mil 65.0 51.7 1966 Days 127.3 18.4 29.1 22.6 197.4 44.3 153.1 2.'84 Rs/mil 86.4 72.2 1967 Days 147.2 21.7 30.3 24.2 223.4 63.9 159.5 2.288 Rs/mil 107.3 87.9 1968 Days 117.9 16.0 25.8 24.1 183.8 61.4 122.4 2.982 Rs/mil 104.1 105.5 1969 Days 102.8 15.2 25.8 19.1 162.9 62.0 100.9 3.617 Rs/mil 102.7 116.6 M-15 (5) Cr,editors'LiquiidationPeriod: The same mix of commercial and policy considerations as in stage (4) above also governs the period of credit obtained from the suppliers of the firm. The computation is as follows: (a) Axrage daily purchases during the vear, ie, (total net purchases in the year/.365), say, P. (b) Average creditors' balance durthe ing year, i e, (opening balance + closing balance)/2, say, C. (c) .-. Average credit period obtained from suppliers = C/P. This period goes to the advantage of- Beview of Management March 1974 for 1969 is the shortest in the five years - 101 days only. This, in turn, gives the greatest number of operating cycles for this year - 3.6 times. The preliminaiy inference from this situarelatively less cash working tion is: capital should be needed in 1968 and 1969 to sustain the same volume of business. (2) The difference between cash working capital requirement and Balance Sheet working capital may also be investigated by examining the pattern of working capital behaviour luring the year. The averaging of opening and closing working capital figures could very well obscure the seasonalor other periodic influences like prebudget buying, procurements against import licences, etc. Possessing internal information, one could also adjust Balance Sheet working capital for obsolete stocks, old debtors, doubtful claims, etc, which should not influence the operating cycle. These points would be equally applicable to the three following cases as well. (3) By dividing the total operational expenses during each year by the respective number of operating cycles,. we arrive at figures of required cash working capital shown against row 8 in the Table. It is interesting to observe that upto 1967 there has been a substantial excess of cash working capital needed over the average working capital amount derived from the Balance Sheet. This leads to a preliminary hypothesis that upto 1967 the OC periods were too long with the result that more cash was necessary to carry on business. In 1968, when the number of OCs cornpleted during the year showed marked improvement, the gap between cash working capital and Balance Sheet working capital is almost nil. And in 1969, with further sharp reduction in the OC period duration, the Balance Sheet working capital substantially exceeds cash working capital. This comparision may be better understood if we consider the 'cash value' of Balance Sheet working capital, i e, all non-cash current assets realised at their full money value, less cash payment of all current liabilities in full. If excess cash working capital were needed for three years upto 1967, where could it have been drawn from' A prima Jaaie answer probably lies in that such additional needs were met out of long-term fund sources of the firm. (4) The two preceding points are a sort of post mortem. But a forward- ECONOMIC AND POLITICAL WEEKLY the help of information contained in Table 1. It has been suggested earlier that cash working capital requirements are a function of. the volume of activity, given a certain duration of the If sales volume is reoperating cycle. garded as an indicator of level of activity, then it may be hypothesised that cash working capital needs would be a positive function of sales volume. In the absence of a common denominator of physical sales for a vide variety of products, we have to accept sales value as a surrogate measure of activity level. This will, however, cause distortions (lue to changes in selling prices which mnay not necessarily have any impact on cash working capital needs. A regression equation could be fitted to, say, the past 10-15 years' sales figures with those of corresponding operational expense amounts. With the help of this equation, for the forecast sales level for a particular yeai, the corresponding operational expense figure could be readily obtained. Although the amount so obtained would by itself have covered the inflationary factor to some extent, quite apart from reflecting the direct correlation between activity level and operational expenses, we may add a further margin to allow for anticipated inflationary price increases. Thus, sales, less excise duty, for Union Carbide increased steadily from Rs 165.4 million in 1965 to Rs 387.3 million in 1969. This represents an average 27 per cent increase in activity level per annum over the quinquennium. If we allow for the fact that during 1968 and 1969 - just following the recession - the rates of increase were much more than normal, then we might assume that sales would register a rise of around 15 per cent in 1970 over 1969. Of course, estimates TABLE Y ear of future changes affecting sales in 1970 would also be used to refine the forecast based on past average behaviour of sales. Assuming, however, that a 15 per cent rise is expected in 1970 in the final analysis, sales would be around 435.4 million. In 1969 the number of operating cycles completed by each unit of money wvas 3.617. Assuming this could be marginally improved upon to 3.7 in 1970, then cash working capital requirement is established at (Rs 435.4 million/3.7), i e, Rs 118 million approximately for 1970. As the rate of inflation per annum is of the order of 6 per cent now, an additional 6 per cent margin on Rs 118 million would yield an estimate of cash requirement at Rs 125 million. The benefit of this calculation is that it focuses clearly on the demand for liquid money for next year's manufacturing and selling operations (not capital expenditure, however). Such an estimate, we feel, is crucial be-. cause the conventional working capital figure by itself may be misleading, despite the fact that cash resources are generated through the realisation of current assets. In fact, non-cash current assets could be managed better if we know the amount of cash working capital needs. Decisions about overdraft facilities could also be better taken if the extent of gap between direct cash realisation through sales plus through realisation of current assets, and operational cash requirements could be more rationally forecast in advance. We have mentioned above the possibility of improving upon the number of operating cycles per year to 3.7 in 1970. More explicitly, it implies a reduction in the duration of the OC period. It may be observed from Table 1 that except in 1967, the durations of LEVER AMITE D 2: HINDUSTAN 1965 Particulars (1) (2) (3) (4) Raw materials in store Conversion period Finished goods in store Debtors' collection period Less (5) Creditors' payment period (6) Operating cycle period (7) Number of operating cycles per vear (365 Row 6) (8) Cash working capital requirement (9) Average working capital as per balance sheet Days 46.6 8.3 26.7 3.9 85.5 21.2 64.3 1966 Days 47.8 7.4 29.7 5.0 89.9 24.9 65.0 1967 Days 44.5 6.7 26.5 5.9 83.6 23.0 60.6 1968 Days 50.5 7.3 23.9 6.6 88.3 24.7 63.6 1969 Days 40.9 7.4 22.6 7.0 77.9 23.8 54.1 6.746 Rs/mil 149.5 167.0 5.615 5.676 6.023 5.739 Rs /mil Rs/mil Rs/mil Rs/mil 127.9 139.8 114.6 152.2 142.9 166.2 153.0 165.3 looking analysis is also possible with M-16 ECONOMIC AND POLITICAL WEEKLY each of the first four phases have shown It is for management a falling trend. to go deeper into each phase and to try to look for possible further economies in any or some of these phases. And, of course, attempts may be made to prolong creditors' repayment period without jeopardising goodwill. The following points need highlighting from Table 2: (1) The difference in the nature of industries to which Union Carbide and Hindustan Lever respectively belong. seems to be clearly demonstrated by the marked variation in the length of their OC periods, and hence the ntunber of operating cycles completed each >-ear by them. Union Carbide manufactures mainly dry cells and torches of various specifications under the famous brand name of 'Eveready'. Hindustan Lever, on the other hand, produces consumer goods like soaps, baby foods, beverages, etc. Viewed in this light, lesser time-spans involved in each and every phase of the OC period for Hindustan Lever, compared to those of Union Carbide, seems inherent in their respective product ranges. A tentative hypothesis could thus be suggested: firms belonging to the consumer goods indu-stry are likely to have shorter OC periods than those belonging to the consumer durable goods industry - at least for the sale-of-finished-goods and realisation-of-debtors cycles. Sometimes, however, bulk-buying of seasonal crops may cause the raw materials-in-store period to be relatively long for consumer goods firms, e g, tobacco or tea. (2) The range of fluctuation in the length of the OC period between 1965 and 1969 is much less for Hindustan Lever (17 per cent, i e,65 65x l00 be contrasted to the changing relationship of these two amounts for Union Carbide shown in It was Table 1. argued there that such changes were possibly due to too long an OC period for Union Carbide until 1967 which caused more cash resources to be deployed to run the business. When in the last two years the efficiency of the OC improved we found relatively less cash resources w ere needed to sustain higher levels of activity. Following this line of reasoning, it seems Hindusthan Lever has been able throughout the period to maintain such a minimum level of OC efficieincy that there has been no occasion when cash requiremnents exceeded Balance Sheet working capital (except in 1965). This is perhaps a healthy sign because it indicates that the rate of conversion or realisation of non-cash current assets adequately meets the cash requirements of business operations. (4) Sales, less excise duty, for Hindustan Lever stepped up from Rs 662.1 million in 1965 to Rs 1,020.0 million in 1969. This represents an annual average rate of increase of about 11 per cent. Since this firm belongs to the consumer goods category, and hence is liable to a lesser degree of fluctuation in activity level, we assume that 11 per cent rate of increase would be maintained for the next year also. Based on this prognosis, estimated sales for 1970 is Rs 1,132 million approximately. Assuming that the 1969 level of operating cycle efficiency is maintained for 1970 also, then the number of operatinig cycles for 1970 will remain at 6.75. Dividing Rs 1,132 million into 6.75, we get an estimated figure of cash requirements at Rs 168 million nearly. Adding a margin of 6 TABLE Review of Management March 1974 per cent for inflation, the final estimate is Rs 178 million. Comparison of Table 3 with Tables 1 and 2 throws uIp the following interesting points: (1) The lengths of the OC periods of Dunlop are more in line with those of Union Carbide, whereas their disparity of Hindustan period with the OC Lever is substantial indeed. The most plausible explanation for this seems to Union be the fact that Dunlop and Carbide fall in the same industrial cadurable goods. tegory, ie, consumer Lever is in an altogether Hindustari different kind of business. (2) Pursuing the comparison between Union Carbide and Dunlop a bit further, it is noticeable that except for the finished goods in store period, all the other four phases of the OC are of quite disparate lenigths for the two firms. This only substantiates the point that the technological and commercial characteristics of the firms are quite difA tailor-made OC period is, ferent. therefore, a more precise guide to cash However, that the two firms needs. belong to a common industrial category is shown by the overall closeness of their net OC periods (row 6), particularly in the year 1969. (3) Compared to Union Carbide, the range of fluctuation in the duration of OC periods for Dunlop is very much less only about 8.6 per cent (111.7-102.3 111.7x 100) over the five-year period. However, this is also half the extent of fluctuation experience by Hinduring the same years. dustan Lever Apparently the argument made earJier that such differences may be attributable to the greater sensitivity of coan- 3: DUNLOP (INDIA) LIMITED than for Union Carbide (36 per cent, i e, 159.5-10' x 100). Although ~Xea-s Particulars 1965 Days 67.7 6.4 23.0 50.6 147.7 36.0 111.7 1966 Days 70.8 5.4 20.2 44.2 140.6 37.4 103.2 1967 Days 76.4 5.9 19.4 45.7 147.4 44.3 10.3.1 1968 Days 73.5 6.8 23.2 44.4 147.9 43.3 104.6 1969 Days 77.1 6.6 24.5 41.7 149.9 47.6 102.3 3.567 Rs/rnil 208.8 .184.8 M-17 we are not here going to suggest an answer to it, yet a question may be raised: is this difference in amplitude of fluctuation attributable to the greater sensitivity of consumer durable goods industry to business cycles, compared goods industry' to that of consumer For, the Indian economy suffered a recession between 1965 and 1968, follow1965 and ing the Indo-Pak war of crop failures.5 (3) It will be noticed from Table 2 that cash working capital requirements are consistently less than average working capital as per Balance Sheet for all the years except 1965. This may Raw materials in store Conversion period Finished goods in store Debtors' collection period Less (5) Creditors' payment period (6) Operating cycle period (1) (2) (3) (4) (7) Number of operating cycles per year (365 - Row 6) (8) Cash working capital requirement (9) Average working capital as per balance sheet 3.540 3.489 3.267 3.536 Rs /mil Rs/mil Rs/mil Rs/mil 141.4 128.4 154.9 137.1 166.7 159.6 189.8 169.7 ECONOMIC AND POLITICAL WEEKLY sumer durable goods firms to business fluctuations in contradicted by the behaviour of OC period in Dunlop. The answer to this riddle may lie in a closer analysis of the relative impact of the 1965-68 recession on a firm like Union Carbide compared to that on a firm like Dunlop, even though both of them belong to the consumer durable grouip of indutstries. (4) The cash working capital requirements of Duinlop have consistently exSheet ceeded the average Balance working capital in all the years. This is so despite the fact that it has had each year a bigger number of operating cycles except in 1969, than those The reasons may of Union Carbide. In again be specifically firm-oriented. other words, there is possibly scope for further reductions in some or all phases cycle for betterment of the operating of operating cycle in the efficiency cash needs turnover. The excess of Sheet working capital over Balance also indicates that such excess is likely to have been supported from longHowvever, from term sources of funds. the standpoint of computing the conventional 'return on capital employed', which includes working capital in the Balance Sheet lower denominator, working capital figure indicates relatively efficient employment of resources. And following this reasoning, Hindustan Lever should be bearing an unfavourable comparison with Dunlop. (5) Dunlop's sales (less excise duty) increased from Rs 397.2 million to Rs 644.4 million over the five-year period, ie, by nearly 62 per cent. This means an average annual growth rate of 12.4 per cent. Considering the fact that this firm belongs to the consumer durable goo.ds group, and that therefore it had responded to a greater extent to b-uciTABLE Review of Management March 1974 even more sensitive to business cycles than a firm in the consumer durables industry. (2) The gap between cash working capital and Balance Sheet working capital for GKW has not, however, behaved the way it has done for Union Carbide corresponding to changes in the OC period. Like Hindustan Lever, GKW's cash resource needs seem to have remained consistently less than Balance Sheet working capital for the fiveyear period. For GKW too, therefore, it could be suggested that the rate of conversion of non-cash current assets has been more than sufficient to satisfy the cash needs of business. This line of argument seems to have some weight when judged against the reverse situation where cash working capital needs are greater than Balance Sheet working capital, e g, Dunlop's case. In the latter instance it would appear that net non-cash current assets are by themselves inadequate to meet the level of cash requirements dictated by the existing state of efficiency of the operating cycle. (3) The fact that average Balance Sheet working capitals are far in excess of cash working capital requirements for both GKW and Hindustan Lever has another implication. This could mean that return On capital employed measurcs for judging managerial efficiency in managing the firms assets are shown in a poorer light due to largerthan-necessary working capital appearing in the Balance Sheet. In other words, sharper focus is thrown on the need for effective management of current assets against the background of estimated cash requirements. And the latter estimate is made possible on an overall basis by computing the operating cycle period. (4) Sales (the product mix of GKW is such that excise duty on its sales is almost negligible) for this firm, increased from Rs 285 million in 1965 to Rs 320 million in 1969, i e, a 12.5 per cent rise in 5 years. The annual average rate has, therefore, been of the order of only 2.5 per cent. Since GKW was worst hit by the recession, and since the producer goods industry group takes longer time to pick uip momentum, we may assume that next year's rate of sales will be more in line with the rates experienced in 1968 and 1969 which were about 4 per cent and 8 per cent respectively, rather than with those of the earlier years. On top of that, with industrial activity picking up, it may be presumed that 1970 sales will register a 10 per cent improveM-19 ness fluctuations than Hindustan Lever, it may not be possible for Dunlop to maintain the average rate of 12.5 per cent, wvhich bears the impact of relatively high growth rates in 1968 and 1969 immediately following the recesLet us, then, assume sion, into 1970. it to be 10 per cent for 1970. Estimated sales is, therefore, Rs 709 nmillion. As the OC period is showing very slow improvement, let us also assume that for 1970 the efficiency achieved is such as to yield 3.75 operating cycles in the year. The corresponding cash working capital estimate is therefore Rs 709 mil/3.75, i e, Rs 189 million approximately. Topping it up with a 6 per cent inflation margin, the final figure is Rs 200 million. The imnportant points to emerge from Table 4 are: (1) GKW belongs to the engineering producers goods indusstry which weathered the worst blast of the 1965-1968 recession. This fact is worth bearing in mind wvhile interpreting data contained in the above Table. Thus, for GKW too, like Union Carbide, the 'hump' year for th, duration of the OC period is 1967. Preceding and following this year, the OC periods behave in a similar pattern for both these firms. This similarity lends again some support to the point made earlier that, as we move up the scale from consumer goods industry to producers' goods industry, there is an overall tendency for the respective OC periods to be more sensitive to cyclical fluctuations in economic activity. But the range of variation for GKW is almost 50 per cent '. 190-95.9 e, --190 xlO x0. This possibly reflects that a firm in the producers' goods industry will tend to be LIMITED 4: GUEST, KEEN AND WILuAIs Years 1965 PartiCUlarS (1) Raw materials in store (2) Conversion period (3) Finished goods in store Days 90.5 13.6 25.4 Days 126.4 14.5 34.6 Days 141.4 15.8 41.2 Davs 127.3 14.1 39.9 Days 71.0 17.9 22.8 70-8 182.5 86.6 95.9 3.806 Rs/mil 73.2 126.4 1966 1967 1968 1969 (4) Debtors' collection period Less (5) Creditors' payment period (6) Operating cycle period (7) Number of operating cycles per year (365 * Row 6) (8) Cash working capital reqUirement (9) Average working capital as per balance sheet 63.9 193.4 80.6 112.8 3.235 Rs /mil 82.1 105.8 5.7 251.2 93.2 158.0 2.310 Rs/mil 117.8 142.2 78.9 277.3 87.0 190.3 1.921 Rs/mil 141.2 171.7 87.8 269.1 119.7 149.4 2.443 Rs/mil 94.2 161.6 Review of Management March 1974 ment over 11969. Based on this preestimate is sales mise, next year's around Rs 352 million. If the nunber of aperating cycles for 1970 is improvestimated cash ed to 4.0, then the working capital need for the year is A 6 per cent addition Rs 88 million. the estimate apfor inflation makes proximately Rs 93 million. ECONOMIC AND POLITICAL WEEKLY First, the level of OC efficiency has always been at a consistently high pitch. Second, as this unit in our sample was most affected by the recession, the scale of operations clicl not expan-id as much as it did for the other three firmns, anid so called for relatively less stretch in cash resources. (2) The principal theme of this article has been the stress on the significance of cash requirements for business operations, relatively to that of conventional working capital. Some moderation is, however, called for in this emphasis too. In times of continu.ous inflation it is not wise to hold high cash balances than necessary. Quite apart from being a sign of inept management of the firm's growth, continually surplus cash balances are bound to suffer erosion in real valuie dtue to persistent inflation. Paton argues in this context that a 1: 1 ratio (insteadl of the u.sual 2: 1) between cash and near cash itelmis and culrrent liabilities should be striven for in most business situation,s. 6 The computation of the OC period, and its application in the manner indicated above, seenms to provide an even clearer and firm relevant measure of the zone of tolerance for holding judicious cash balanices on a continuing basis. This is not to suggest that current assets are to be or can be eliminate(l. The point is that having estimated annual cash requiirements on a more systematic basis, the management and conversiotn of non-cash current assets could be effected in such a manner as to ensure that the cash level norm is maintained fairly consistently. (3) The estimation procedure for cash requirements outlined above relates only to the operating aspects of the i e, buying, business, manufacturing, selling, etc. Cash is required for at least three other major activities namely, repayment of loans, investments in capital items, and dividen(d payments. Provisions for these have to be super-imposed on cash needs for operations. And the proper context for doing this is the overall fun(ds flow analysis carrie(l out at the beginning of each period. While dividend payouts and loan repayments could be known fairly correctly the former being based on standard company policy, and the latter being governed bv contract terms the capital expenditture programme is a matter of careful decision-making. Total cash budgeting shall have to awvait the capital expenditure decisions which may in turn have significant financing implications both short and long term.7 (4) It is generally recognised that firms tend to suffer cash shortages during periods of growth and expansion. Correspondingly, due to lagged effects, onsets of decline in btusiness activity are likely to be associated with surplus cash. We, therefore, tried to interpret the calculations for the four firms chosen for this study in terins of the industrial recession during 1965-68. In our sample, Guest, Keen and Williams was the worst hit firm, while Hindustan Lever was perhaps the least affected by the recession. Both firms exhibit lesser cash requirements than Balance Sheet working capital, except in 1965 for Hindustan Lever. But the significant fact is that the gap between the two figures is consistently very much larger for GKW both in absolute amounts and in percentages - than for Lever. This seems to lend support to the phenomenon of surplus liquid funds withheld (via capital replacements, scaled dowZn purchases and inventories etc) during declining business activity.& In comiiparing Dunlop with Lever, however, we find that explanation through recession loses some force. Dunlop belongs to the consumer durable goods (or intermecliate goods, according to RBI) indtustry, while Hindustan Lever is a consumer goods firm. The impact of recession on Dunlop should, therefore, have been more pronounced than that on Lever. Duinlop should, accordingly, have produced evidence of cash surplus (i e, lesser cash, requirements than working capital) to a greater extent than Hinclustan Lever. The figtures, howvever, produce a very contrary picture. Dunlop's cash requirements have always been in excess of working capital. The average increase in sales over 1965-1969 for Dunlop and Lever were nearly equial, i e, 12.4 per cent and 11 per cent respectively. It cannot possibly be forcefully argued, therefore, that Du-nlop's operations expanded at a mtuch faster rate than Lever's (although one would have expected Dunlop's sales to have grown in fact at a smwlaller rate than Lever's). A better explanation may, therefore, lie in the relative efficiencies of the OC periods for the two firms. g;iven the industrial categories to which the-y respectively belong, the OC period for Dunlop is perhaps so high as to require excess cash than warranted by working capital - even during recession. Cor respondingly, Lever's OC efficiency being high, it is able to do with less cash than indicated by the cash value of its working capital. This may indicate lowering the amoulnt of working Consolidating Comments (1) In the workings presented above, we have incltuded cash in Balance Sheet working capital computations. It may have been more appropriate to exclude cash from such calculations because we were comparing cash requirements with current assets, less cuirrent The implication in convenliabilities. computations capital tional working current assets just mentioned is that get converted into cash during the finafter paying off ancial period which, provides for liabilities, the current expenses. other operational meeting The paradox, however, is that suich current assets as are lelied upon to yield cash, themselves need to be supported by funds until conlversion into cash. It is worthwhile to remember that increase in working capital represents an application of funds, and not a source. In other words, large amounts of current assets need not necessarily be a rational The mesource of financial comfort. the operating cycle thod of computing period outlined above in fact leads to longer OC periods for larger inventoThis, in tum, imries, debtors, etc. turnover rates, dictating plies slower more cash requirements, to support inUnless, therefore, tervening operations. the length of the OC period is shortened, increasing balance sheet working capital could induce cash requirements which exceed such capital. This hypothesis seems to be corroborated in the 1967 Until case of Union Carbide. when the OC period ranged between 150 and 159 clays, cash requiirements Sheet Balance exceeded consistently working capital, despite the steady rise in the latter amount too. When, however, in 1968 an(d 1969,. the OC perriods came down- sharply, cash requirements were almost equal to and less than (respectively) conventional working capital despite continuing increase in the latter. Guest, Keen and Williams, however, presents a different picture. Although the OC periods variecl from a high of 190 days to a lowv of 96 days, cash requirements seemed always to be less than Balance Sheet working capital. There could be two reasons for this. M-20 ECONOMIC AND POLITICAL WEEKLY for improving the capital investment rate of return on capital employed. (5) We have used sales forecast (the method for deriving it coulcl of course be much more refined in practice than here)9 as the independent causal variable in -stimating cash requirements for the year In fact, it is in 1970 in each case. requirement, of cash the projection along with sales forecast, for the next period that the OC period should prove more useful than in performing the kind of post nmortem analysis outlined above. How does working capital, as convenrelate to sales or computed, tionally tturnover in comparison w ith the cas'h requirement-tumover relationship' Working capital is the net resultant of balancing betwveen several items, and of varying valuation bases for some of them. several points why Grass has listed w%orkingcapital may not vary directly with sales, some of which are mentioned below 10 (1) Level of wvork-in-progress depends on the length of the manufacturing time-cycle, and therefore on the producits and the product mix. (2) Work-in-progress is geared to outcost, not put at manufacturing turnover. (.3) Finished stock levels depend upon commercial factors. (4) Debtors levels depend on credit terms and liquidity of customers. (5) Creditors are geared to purchases rather than turnover, etc. the same current derived by netting item grotips. A little reflection xvill show exists in fact. that no suich anomaly Balance Sheet working capital (interim or annual) is a static picture of the net includinig cash. current assets position, When the opening and closing balances of these itemiis are linked with the relevant operational activities of the firm in the process of computing the O(C period, these figtures get re-interpreted in a dvnamic context. And an estimation of cash needs for operational purposes is feasible only throtugh such linking of current items to the technological and comnamics of the firm. mercial (dy Review of Management March 1971 inore over that period. Otherwise, recent years couild have been considered as Mwell. (9) Baniks in India are reported to miake use of the OC calculations for tobacco, seasonal industries like tea, sugar, etc. They do not rely upon the annual Balance Sheet figures to ensturo of over(drafts in relation to security Many well managed these industries. firms themiselves also employ these calcullations to watch their own cash movements. However, it does not seem to be a wvile'y used approach in industrial houses. The simple presentation of the method in this paper may contribute to a better monitoring and managing of cash wvorking capital. (10) Finally, in our computation of the OC periods above, we have assuime(l collectioni of debtors to result directcases in ly in cash-inflowv. In most practice, however, this is not so. For, constitute much of stuch realisations cash-in-trans-t, che(Itues to be cashed and the like. In consumer goods industries this may be an important factor. A calculation of cvcle period for cash inflow on the same l)asis as for debtors' collection shown above may, therefore, l)e made and added as a sixth element in the OC period. (7) The foregoing analysis is subject to the basic limitations of an external investigator havinig to rely on ptublished Thus, the use of informatioan alone. average w-orking capital on the basis of balances only is and closing opening liable to errors because the levels of working capital dturing the year could be (llite different from the opening and closizng figuires. This may be especially true of seasonal businesses.12 But for the kind of firms analvsed in this paper ignoring the seasonalitv factor seems realistic. There is no apparent reason to think that the year-end Balance Sheet figures for these firms represent the culmination of a 'natural' business year and inventories wifh rock-bottom accounts receivables and high liquidity. lines within Again, different product distinct the same firm might exhibit Cash characteristics. operating eycle be more refined and It is precisely such factors as Grass has estimates coulll which have been explicitly highlighted accurate if the OC calculations are done incorporated in the operating cycle separatelv for each product line. HowEach above. methodology elaborated ever, the basic intention in the article step in the OC period computation leacds has been fo demonstrate the uise of Ihe to the assessment of- the impact of the OC concept, and not to throxv up definitransformation process of each current tive concltusions about the management asset item on the firm's casbh resources. of cash working capital or cturrent items The operating expenses for the next year, in the fotur firms analysed. derived from sales forecasts and adjustthat after (8) It may be suggested an(d wvork-in-pro- having forecasted 1970 ments for inventories cash working gress, are then used to estimate cash, capital needs above, xx'hy not compare and not so-called working capital requirefrom these with actuials as available ments. The derivation of cash require1970 published accouints. This has not ments through this process seems to be been done for the simple reason that the more obviously linke(d to sales or turan- blanket assuimptions made by uis abotit various elernents of the OC computaover, than is the link of conventional wvorking capital to sales, although over projections, without tions andl sales the long term the latter relationship into any dialogtue entering wvith the in natture. should also broadly hold good. It firms, are onlv illtustrative (6) It may be arguted that it is an Comparisons of forecasts in this paper anomaly to use the same cuirrent asset with the acttuals xvouild, therefore, conand current liability figuires from the It is, hi)wvever, little meaning. vey balance sheet for computing the length likely to be a uisefuil exercise for the of each phase of the operating cycle, internal analyst. Besides. the period calculating the OC turnover riate from 1965-69 was chosen to cover the recesthence and finally the cash estimates, and sion spell and to relate Balance Sheet then comparing it w7ith wzorking capital capital movements andl casha working Notes [This paper has benefited from the and suggestions made comments by A Sen. Any shortcomings are this auithor's.] Some w7riters, however, prefer not to include cash in vorking capital since cash is the effect rather than of working the cause capital changes. For example, see "Control of Working Capital", (ed) M Crass, Goower Press, Essex, 1972, p 6. Btit the ca.sh view of working capital seems most effectively supported for a firm wvhich is planning to start its operations for the first time. Evidence for this interpretation seems also to be contained in assertions like "working capital is to be provided for to the extent of 6 mornths' works cost of production". OIIly a cash view of this amount can carry clear conviction. See Report on The Fair Ex-Works Retention Prices of Steel for the Period 1st April 1960 to 31st March 1962, Tariff Commission, Government of India, Bombay 1962, p 43. Correct comparison seems possil)!e only wbhen we have azn estimate of total cash requirements for operations during a period, as dist.nct from convent.onally dlfined working capital. Park. C and Gladson, J W, "Work ing Capital", Macmillan Co, NewN York, 1963, Chapter 3. a Theory o Sagan, J, "Tow ard M-21 I 2 3 Review of Managemenit March 1974 Working Capital Management", in "Financial Management - Policies and Practices", (eds) F J Corrigan and H A Ward, Houghton Mifflin, Boston, 1963, p 186. Lee, T A, "A Case for Cash Flow Reporting", Joutrnialof Business Finance, Volume 4, Number 2, Summer, 1972, pp 27-36. See "On Recent Recessionary Trend in Organised Industry", Reserve Bank of ItndiaBulletin, July 1968, pp 862-69. The RBI industrial classification is different from ours: its categorisation being Basic Industries, Capital Goods Industries. Intermediate Goods Industries and Consumer Goods Industries. The study has contrasted the wide fluctuations in growth rates of output of basic and capital goods induistries gained the nearly steady declining rates of the last two groups. GKW, which falls in the capital (our producers') goods industry, has thus shown the widest fluctuations. Dunlop and UCIL fall in RBI's intermediate goods group, although a distinction based on durability is also logical. Paton, W A, "Observations on Inflation from an Accounting Stand", Journal of Accounting Research, Volume 6, Number 1, Spring 1968. p 84, For a simple methodology of assessing overall cash surplus (or shortage) situation in the context of funds flow analysis see Jackson, A S, and Townsend, E C, "Financial Management", George Harrap, London, 1970, pp 157-62. See for example, Cohen J B and Robbins, S M, "The Financial Manager" Harper and Weatherhill International, Tokyo, 1968, p 300: "(The] tendency for companies to become cash-poor as the tide ot economic prosperity rises and cashrich as it runs out is a well known economic phenomenon." See Weston, J F and Brigham, E F: "Managerial Finance" HoIt, Rinehart and Winston, New York, 1972, pp 73-77. They have refined the 'percentage of sales method' by computing the ratio of each item of current asset and current liability to sales. The use of these ratios for forecasting working capital needs is suggested after duly tempering them with an understanding of basic technology and the logic of sales-to-current items relationships for the firm. We have, however, suggested only one relationship in the OC concept above cash to sales. All current asset items are transformed into cash as it were. Weston and Brigham suggest more refined forecasting techniques also, e g, linear regression, multiple regression, etc. Grass, op cit, p 7. Most authors seem to hold the sales-to-working capital causal relationship to be true. Thus, Archer, S H and D'Ambrosio, C A, state: "In general it is possibly safe to ECONOMIC AND POLITICAL IVEEKLY say that the size of working capital same poiiit, op cit, p 72. ... is usually a function of sales, as 12 This point has also been highlightare fixed assets", "Business Fined by Jaedicke, R K, and Sprouse, ance: Theory and Management", R T, in "Accounting Flows: InCollier Macmillan International, comes, Funds and Cash", Prentice New York, 1972, p 31.3. Weston Hall, Englewood Cliffs, New Jersey, and Brigham also emphasise the 1965, pp 109-114. 4 5 Psmare 6 7 8 9 SCI caters to Daried requirementsby operating a uniquely diversified modernfleet comprising cargo liners, bulk carriers,tankers, colliers, oreloil/grain carriers,timber carrier, and passenger-cum-cargo ships. 0 1 Shipping House, Madam Cama Road, Bombay 400 001. portsof the world. Agentsat all principal M-22