Finology
Finology

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Reduction of Net working Capital requires understanding the networking of Capital. At the threshold we all are aware that Net working capital is the difference between Current asset and Current liability and is therefore requiring consistent attention of the corporate honchos being a very dynamic measure of performance. Net working capital or otherwise called the Working capital gap involves an interest cost either in the form of an opportunity cost or actual borrowing cost and hence requires an effort to keep it at an optimal level. It is important to understand the structure of current asset and current liability in an organisation truly from management perspective and not just statutory angle. Definitely an increase in current assets (including cash and Bank Balance) more than current liability is viewed as signs of inefficiencies in business. While an increase in cash or bank balance is a matter of inefficient investment policies, an increase in debtors or inventories is a matter of inefficiencies in operating cycle. When both current asset and current liability move in the same direction and extent, the net working capital will not change. Therefore the challenge remains high in reducing the current asset without reducing the current liability or keeping it constant in the picture.

We can appreciate the topic better by depicting a typical net working capital computation as below,

Particulars

 Rs. in lacs

 Inventories

           100

 Net Debtors

           100

 Charges/Advances/Claims

              50

 Advance Tax / TDS / Deferred Tax

              25

 Cash & Bank

              25

 Other Current Assets

 Total Current Assets

           300

 Sundry Creditors

           100

 Provisions

              50

 Total Current Liabilities

           150

 Net Working Capital

           150

 Investments

              10

 Net Fixed Assets

           300

 Total Capital Employed

           460

 Financed By:

 Equity + Reserves OB

           300

 Short Term Loans

           160

 Inter Branch balances

 

 Financed By Total

           460

There needs to be a clear distinction between current liabilities and short term borrowings. Current liabilities arise as a result of operating cycle and short term borrowings are meant to finance the working capital gap. For e.g. there could be a tendency to classify overdraft with Banks as current liabilities, but ideally they are sources of short term funding. Logically, we cannot finance such overdrafts again and show anything as a source of finance corresponding to them and hence could be the logic of showing them as source of finance.

From the above computation format, one gets to conclude that the net working capital or the working capital gap can be funded 100% by short term loans and the Long term assets namely investments and fixed assets are predominantly funded by Equity plus reserves. Current assets are financed either by Current liabilities or by borrowing outside for short term. Realisation of current assets other than cash and Bank balances is of no use if the realisations are again parked in short term investments (say  cash or cash equivalents) or kept idly in Bank, since this is going to remain in the same bracket of current assets. Alternatively, even if the realisations are used to repay the trade creditors or statutory obligations etc, it is not going to apparently make a dent on net working capital. Therefore the best method under this circumstance to use the realisation on debtors or other current assets to pay off the short term finance which brings down the net working capital as well. This can be explained by means of comparing two scenarios

Consider a situation where there is a realisation of Rs.50 on debtors and the following scenarios,

Particulars

Pay Creditors

Pay short term loans

 Inventories

100

100

 Net Debtors

50

50

 Charges/Advances/Claims

50

50

 Advance Tax / TDS / Deferred Tax

25

25

 Cash & Bank

25

25

 Other Current Assets

 

 Total Current Assets

250

250

 Sundry Creditors

50

100

 Provisions

50

50

 Total Current Liabilities

100

150

 Net Working Capital

150

100

 Investments

10

10

 Net Fixed Assets

300

300

 Total Capital Employed

460

410

 Financed By:

 

 Equity + Reserves

300

300

 Short Term Loans

160

110

 Financed By Total

460

410

Sources of Short term Finance and their relationship with NWC:

Short term finance exists in various options and widely popular from Banks. The options widely resorted to nowadays are Bill discounting (both Domestic and Exports), Packing Credits, Supplier/Buyer Credits etc.

1. Bill discounting, as we all are aware, is the upfront financing of Sales invoices after deducting a cost in the form of discounting charges which is a compensation in the form of interest to the Financier. Thus, all the seller does is raising the invoice and collecting all the documents, submitting the same to the Bank for availing the advance. The recommended accounting practice depends on the recourse available to the Banker.

a. If it is a scheme where the Banker has recourse to the Seller if the customer does not pay the amount of invoice, ideally the seller can reduce the debtors in his books of accounts, but has to show a contingent liability for the obligation that may arise in future on account of default by the debtor. However, this is the widespread practice prevalent. There are other accounting practices which carve out the discounted portion of the debtors and place it as a separate item of debtor which is of no use since it is a movement from one pocket to the other.

b. If the Banker does not have recourse to the seller on default by the customer, it is a simple case where the debtors are reduced and seller need not bother about the collection.

The main point here is Bill discounting does not create a source of finance in balance sheet. As pointed out above, Bill discounting is handy to reduce the net working capital to the extent only if there is a necessity to repay another source of funding. But one cannot rule out the marginal impact of the discounting charges on the working capital. Currently the rate of discounting varies from 4.5% - 6.5% on export bills. Assuming from the above table showing net working capital, an amount of Rs.30 lying in debtors is discounted @6.5%, there is a reduction from debtors to the extent of Rs.30 and what gets added to Cash/Bank balance is only Rs.28. Thus there would be a reduction in NWC by Rs.2.

2. Packing Credits are extremely popular means. They are meant to fund the seller to execute a particular customer order. It is available for both exports and domestic sales and is a preshipment credit. But the seller can always repay the packing credit from collections under a different order or customer. Packing credit is shown under source of finance and it is not definitely justifiable to say that it results in an increase in debtors. However, when an invoice is realised, the current asset is reduced and the collections only go to bring down the source of finance thereby implying a reduction in the net working capital.

3. Supplier credit is a means of financing the payment to be made to the supplier. It has the effect of reducing the creditor and on the other hand increases the source of finance. This has an adverse effect by increasing the net working capital immediately. But considering the fact that future realisations for e.g. from debtors can go on to offset this liability, there is no impact on net working capital because of availing supplier credit.

While resorting any of such external sources of short term finance available to reduce net working capital, one should keep in mind that in pursuit of reduction of working capital we cannot allow the actual interest cost on borrowings to overshoot the opportunity cost of holding high WC.

Internal arrangements:

There are internal arrangements possible which can help to achieve the objective discussed in this article.

1. Creating Long term Asset:

If the organisation is a unit or division of an entity, the net working capital can be reduced by lending the idle cash to other divisions or units which are in need of funds. Referring to the format given in the beginning of the article, inter office funds or balances need not form part of the current assets since they may or may not be collected in a short term. Alternatively the organisation can create assets in the form of long term loans and advances outside the entity which will then not get classified under ‘Current Assets’. The other option is to utilise the idle fund for purchase of fixed asset which flows the fund out of the purview of working capital or in other words means a reduction in net working capital.

2. Inventory over Debtor:

It sounds unconventional to say that an organisation can prefer a certain amount to lie in inventory rather than debtor while looking plainly at numbers. This is possible only in an industry which does not adopt a make to order model of production, because in such cases there is no option but to deliver the goods on time to customer and thus creation of debtor is inevitable. But whereas in an industry which does not follow market ‘pull’ goods can be produced as per the forecast of the company which gives it the flexibility to retain inventory and push it may be in the following month. Now, coming to the rationale of preferring inventory over debtor on the working capital assessment date is the reason of margin which inflates the working capital numbers.

The extent of Working capital reduction that can be achieved also depends on the method of costing followed. To explain with an example, the following scenario is drawn assuming there is no opening stock for simplicity.

Particulars

 Variable costing

 Total costing

Closing stock

                      1,000

                 1,000

per unit cost of production

                            10

                       20

Sale price

                            30

                       30

Value of inventory

                    10,000

               20,000

Value of Debtors if sold

                    30,000

               30,000

Increase in working capital

                  (20,000)

             (10,000)

3. Prudent provisioning:

Current liabilities include various provisions for foreseeable expenses or losses. Adding a genuine provision visibly brings down the Working capital gap as well. Organisations must ensure to leverage with the areas requiring provision in line with the GAAP e.g. provisioning for inventory obsolescence.

4. Reduction in Inventory:

It does not mean creation of debtors but optimising the level of inventory while meeting the business requirements. Given the type of business model, one can actually plan for Just in Time inventory systems and reduce the Work in progress.

5. Renegotiation with Creditors:

The Vendor development department can play a vital role in making the most of supplier’s mercy and get the best competitive credit terms prevalent in the market. Certainly not to mess up with MSMEs....


 

Published by

CA S.SAIRAM
(IFRS Consultant)
Category Others   Report

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