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Teaching Note

BBC PVT. LTD. AND WORKING CAPITAL CHALLENGES

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Nimisha Kapoor and Professor Sandeep Goel wrote this teaching note as an aid to instructors in the classroom use of the case BBC PVT. Ltd. and Working Capital Challenges, No. 9B12N026. This teaching note should not be used in any way that would prejudice the future use of the case.

Richard Ivey School of Business Foundation prohibits any form of reproduction, storage or transmission without its written permission. Reproduction of this material is not covered under authorization by any reproduction rights organization. To order copies or request permission to reproduce materials, contact Ivey Publishing, Richard Ivey School of Business Foundation, The University of Western Ontario, London, Ontario, Canada, N6A 3K7; phone (519) 661-3208; fax (519) 661-3882; e-mail [email protected]. Copyright © 2012, Richard Ivey School of Business Foundation

SUMMARY OF THE CASE

Version: 2013-05-16

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The case describes the dilemma of a company in urgent need of funds in order to secure an important contract. BBC Pvt. Ltd. is a chemical manufacturing company under the management of Arpit Agarwal and Mukesh Kumar. The company manufactures and sells stable bleaching powder. Through the use of adsorption, BBC is able to manufacture a product which involves lower investment in the form of fixed assets; although the product is also of an inferior quality, the company is able to pass on that cost advantage to its end customers. This cost advantage enables BBC to maintain its position in the market. In addition, the company sells the product primarily on credit and is therefore a preferable option for buyers.

No

BBC has followed a traditional approach to working capital management. Its assets are much greater than its liabilities. The company repays its creditors promptly before the credit period. However, in terms of credit management, the company follows a casual approach. It extends credit sales for large periods and its large inventory in the form of raw material and finished goods has resulted in excessive blockage of working capital. In 2012, the company bid on a contract with Indian Railways (IR) that will require significant investment immediately. Agarwal needs to make decision about how to secure adequate funds for the upgrade that BBC needs in order to fulfil its promising contract.

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LEARNING OBJECTIVES

The case stresses the importance of working capital management in a business for its short-term survival and long-term growth, and can also be used to develop insight with respect to working capital management.

This Teaching Note is authorized for use only by NAJAM SAHAR, Riphah International University until Apr 2019. Copying or posting is an infringement of copyright. [email protected] or 617.783.7860.

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In addition, this case can be used to illustrate and discuss key issues regarding inventory management, debtors/receivables management, creditors management, cash management, Just-In-Time (JIT) manufacturing and operating cycle. COURSE POSITIONING

This case can be used to discuss the theory and practice of working capital management with graduate and undergraduate management students in finance courses. It can also be used in executive programs to discuss the concept and application of optimization of working capital.

Pre-class Preparation

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TEACHING PLAN

Three hours of pre-class reading and analysis based on the assignment questions is recommended. At the least, students should read the case carefully before coming to the class. Total time for class discussion — 90 minutes

20 minutes: 20 minutes: 20 minutes: 10 minutes:

Discuss the concept of working capital management and the significance of realizing the optimum level of working capital in a firm. Discuss the concept and application of inventory management. Discuss strategies for effective management of receivables and payables. Explore methods of effective cash management. Evaluate the growth prospects for this company.

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20 minutes:

DISCUSSION QUESTIONS

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1. Was BBC’s working capital policy successful? Why or why not? 2. BBC’s inventory turnover ratio (ITR) decreases from 2009-2011. Calculate ITR and analyze the efficiency of the company’s inventory management. 3. Evaluate the company’s cash position with focus on its credit policy towards receivables and payables. 4. Is BBC a growing company? Which areas should be improved in the company for future growth? ANALYSIS

1. Comment on the working capital policy followed by the company.

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Class discussion can begin basic analysis of BBC’s working capital practices. As the case notes, the company follows a traditional approach to working capital management, which is evident from its liquidity position.

This Teaching Note is authorized for use only by NAJAM SAHAR, Riphah International University until Apr 2019. Copying or posting is an infringement of copyright. [email protected] or 617.783.7860.

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Working capital is the difference between current assets and current liabilities.1 It can be defined as the amount of funds required for the day-to-day trading operations of a business and pertains to maintaining an adequate level of liquid resources. It is also a measure of a company’s efficiency and short-term financial position. A company’s working capital policy directly affects the profitability, liquidity and structural health of the organization. Most importantly, it determines the degree of ‘operating risk’ involved in a business. There are many factors that determine a company’s working capital requirements.2 Students can be asked to discuss some of these factors, such as:

   

General Nature of the Business: The working capital requirement of a firm depends upon the type of business involved. Size of the Business: The larger the business, the greater the amount of working capital required. Production Policy: The company’s production policy determines the amount of working capital required. If the policy is to maintain inventory in advance, then the amount of working capital required would be high. Operating Cycle: The length of the operating cycle determines the working capital of a company. The longer the operating cycle, the higher the amount of working capital required (and vice versa). Credit Policy: A liberal credit policy requires more working capital than a stringent credit policy.

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

The instructor can then introduce a discussion on the various approaches to working capital management. There are two basic types of financing that a firm can adopt for its current assets: long-term financing and short-term financing. Depending on the mix of short- and long-term financing, the working capital approach followed by a company may be broadly referred to as either:3



A conservative approach: The financing policy of the firm is said to be conservative when it depends more on long-term funds than short-term funds for financing needs. An aggressive approach: An aggressive policy is one in which a firm uses more short-term financing than long-term financing.

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

No

BBC’s current assets are mainly in the form of inventories, sundry debtors, cash and bank balance and loans and advances. The company’s levels of current assets are very high, as represented by high current ratio and quick ratio. The current asset as a percentage of total asset is around 65 per cent for BBC, whereas the average ratio in the manufacturing sector is 30 per cent. At this point the class discussion can be guided towards the need for an ‘optimum’ level of working capital in a company. Excessive working capital may prove disadvantageous to the company for a variety of reasons, such as: Excessive working capital means idle funds which yield no returns for the business. It may lead to theft, waste and losses. It can result in excess debtors/receivables and poor credit policy. It may lead to decline in the value of the company’s shares because of low return on capital employed (ROCE).

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1. 2. 3. 4.

1

M.Y. Khan and P.K. Jain, Financial Management: Text, Problems and Cases, 6/e, Tata McGraw Hill, New Delhi, 2007, p. 13.4. 2 Ibid. p. 13.13. 3 ibid. p.13.6.

This Teaching Note is authorized for use only by NAJAM SAHAR, Riphah International University until Apr 2019. Copying or posting is an infringement of copyright. [email protected] or 617.783.7860.

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On the other hand, a shortage of working capital is equally undesirable, as it means insufficient funds for business operations and may result in discontinuance of business in the long run.

In contrast to BBC, which has a large amount of working capital, some companies maintain negative working capital through effective credit policy. These companies have high deferral periods and shorter collection periods. Such companies also make quick sales and invest the realized cash in commercial papers and certificates of deposits that earn them good returns in the short term.

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The instructor can now lead the discussion towards the current asset utilization in the domain of working capital management. BBC’s levels of current assets are very high and it eventually led to an unproductive blockage of funds. The ratio of current assets to total assets has been in the range of 62 to 66 per cent from 2009 to 2011, whereas the benchmark of the manufacturing sector is 30 per cent. This indicates a high degree of ‘operating risk.’ The company should reduce its current assets so that there are funds available for contingencies.

2. The inventory turnover ratio (ITR) decreases from 2009-2011. Calculate ITR and analyze the efficiency of the company’s inventory management.

A large amount of BBC’s working capital is blocked in the form of inventories. The company’s financial statements reflect an enormous increase in these inventory levels from 2009 to 2011.

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As the case notes, accumulated inventory can be categorized into three main groups: raw materials, finished goods and packing materials. From 2009-2011, the levels of all three of these types of inventory have risen significantly. Although such high levels of inventory eliminate the possibility of disruptions in manufacturing due to a stockout, it has led to wastage and blockage of BBC’s working capital. Instead of this practice, BBC could follow a lean manufacturing system like just-in-time (JIT).4 In a JIT system, materials are ordered as and when they are needed. The necessity of carrying large amounts of stock is therefore eliminated, saving storage and other related costs.

No

BBC follows the first-in-first-out (FIFO) method of inventory valuation.5 Under this method, it is assumed that materials are issued to production in order of their arrival. This implies that inventory costs will be computed on the assumption that goods sold or materials consumed are those which have been stored for the longest period of time; therefore, those remaining in stock represent the latest purchase or production. In this way, period-end inventory will be closer to market value. The FIFO method will undercharge the production in case of inflation and overcharge in case of falling prices. The balance sheet may reflect the true value, but the income statement may be distorted under the two price-level situations.

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Therefore, a better way of inventory valuation may be the concept of weighted average.6 This method of inventory valuation attempts to moderate the extremes of FIFO with the objective of arriving at a perfect combination of realistic cost of goods sold and period-end inventory. Weighted-average valuation averages the cost of all units purchased at various points in time and at various periods during the accounting year. Weighted average is calculated by multiplying the unit of cost by each lot size and then dividing the resulting figure by the total number of units purchased. 4

Y. Sugimori, K. Kusinoki, F. Cho and S. Uchikawa, “Toyota Production System and Kanban System Materialization of Justin-Time and Respect-for-Human System,” International Journal of Production Research, 1977, 15:6, pp. 553-564. 5 W.J. Bruns Jr., “Inventory Valuation and Management Decisions,” The Accounting Review, 1965, 40:2, pp. 345-357. 6 Ibid.

This Teaching Note is authorized for use only by NAJAM SAHAR, Riphah International University until Apr 2019. Copying or posting is an infringement of copyright. [email protected] or 617.783.7860.

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The instructor can move the discussion to the high inventory maintained by BBC. Clearly, this method of inventory valuation is not beneficial for the company as it represents blocked funds and may lead to costs associated with deterioration and wastage. When the company is trying to muster funds for the IR contract, this method of valuation will only restrict funds even more.

3. Evaluate the company’s cash position with focus on its credit policy towards receivables and payables.

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Cash management a critical area for small companies. It involves managing the monies of the firm to maximize cash availability and interest income on any idle funds.7 Management should continuously work to maintain cash at optimum levels. Whenever there is excess cash, it should be placed in liquid short-term investments, such as call money, intercorporate deposits, commercial papers and certificates of deposits, instead of remaining idle. This will not only help the company in meeting its cost of capital but will also ensure that funds are available at all times, acting as a cushion for the company in contingencies like the one which BBC currently faces (largely because of inefficient management of payables and receivables).

Most of BBC’s sales have been in the form of credit. This has resulted in large amounts of receivables. A significant amount of the company’s funds are blocked in the form of these receivables. BBC has been very liberal in extending credit sales to its customers, which have remained unrealized for as long as two years. A major area of concern for the company is therefore receivables management. Receivables management is one of the essential parameters for effective liquidity in a business.

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The instructor can now move the discussion towards the significance of liquidity position regarding receivables’ management. The class can review the data in Exhibits 1-3 of the case and see that BBC enjoys a very high liquidity position, which is described by its current ratio and quick ratio. For the financial year 2010/11, the company’s current and quick ratios were 15.8 and 12.8, respectively. However, BBC’s current and quick ratios are high only because of increased current assets, which are not beneficial for the company. The major accounting head here is debtors only second to inventory.

No

BBC needs a sound collection policy because its customers do not always pay the firm’s bills promptly. Collection efforts should aim at accelerating the collections from slow payers and reducing bad-debt losses. Students should understand that a sound collection policy should ensure prompt and regular collections. By not collecting promptly, the company not only faces the problem of insufficient cash for its day-to-day operations but also loses the interest that it would have earned by investing that cash in various liquid short-term investments. There can be a short discussion at this point on the concept of ‘opportunity cost,’ as BBC is incurring an opportunity cost in neglecting to collect payments on time.

Do

Accounts payable is another useful working capital financing option. Accounts payable includes trade credit and accrued expenses of the business. These funds represent an alternative to the funds raised through formal institutional channels. This is because the suppliers, being close to the buyers, have better information about the creditworthiness of a buyer and also enjoy greater control over the buyer than institutional financing agencies. Hence, they can offer better terms to the buyers in extending trade credit. The longer the time allowed for payment, the lower the net present value of such payment and the higher the value to the firm. Thus, a company on a growth trajectory should have higher levels of current liabilities.

7

James C. Van Horne, Financial Management and Policy, 12/e, Pearson Education Inc., New Delhi, 2002, pp. 431.

This Teaching Note is authorized for use only by NAJAM SAHAR, Riphah International University until Apr 2019. Copying or posting is an infringement of copyright. [email protected] or 617.783.7860.

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BBC has not used its creditors’ terms to its advantage. The company has been quick in repaying its debts. This can be inferred from the significant decrease in the sundry creditors of the firm from 2009 to 2011, which has resulted in a tight liquidity position of the company. If the company makes full utilization of the credit being extended by the suppliers, it can lead to availability of extra funds to carry on day-to-day operations. Thus, a company willing to pursue expansion should exploit its available credit as long as the trade creditor allows.

4. Is BBC a growing company? Which areas should be improved in the company for future growth?

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BBC cannot be called a growing company. The company’s gross block has been continuously decreasing at a significant rate. This means that instead of growing, the company is actually shrinking — and at a rapid rate. There are many areas that require improvement if the company aspires for a turnaround.

The company needs to put extensive work into areas of inventory and receivables management in order to see a turnaround. Its sales have not grown from 2009 -2011. Significant efforts are required to convert the finished goods into sales. This will not only reduce BBC’s inventory levels but will also help the company in growing further. BBC should take full advantage of the ‘grace’ periods offered by its suppliers and try to reduce its credit periods to customers for better liquidity. Due to wide fluctuations in the price of raw materials, the company is unable to predict suppliers’ cost and the actual funds required. This has been another major hindrance in BBC’s credit management. In terms of debtors’ and suppliers’ management, the company’s credit management is not very sound and needs continued improvement.

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Operating cost is a major factor for working capital. BBC has the advantage of low fixed and operating costs due to its adsorption technique of production, which allows the company to pass on this cost advantage to its consumers. It should build further on this for long-term viability.

No

The orders from private accounts are smaller than those from the government. Accordingly, BBC should try to secure more government orders in the long term, as it is doing. If BBC succeeds in winning the current IR contract, this may bring the company back to the growth trajectory. The company should try to convince its bank manger to grant loans at a lower rate of interest and softer terms due to past tie-ups for infusing the sorely needed capital into the business (and for the IR contract in particular). Industry giants like the Aditya Birla Group, the DCM Group, Grasim Industries Limited, etc. are BBC’s suppliers of raw materials as well as the company’s major competitors. Survival in this atmosphere is a struggle for BBC and will depend upon a sound working capital.

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As part of a hazardous industry, BBC must be very careful about environmental issues. Extra safety measures are required for this, which in turn depend upon availability of funds. This will need to be included in the company’s plan for long-term growth. The instructor can conclude the discussion with a note on the significance of efficient working capital management for long-term growth and sustainability as well as with smooth day-to-day operations.

This Teaching Note is authorized for use only by NAJAM SAHAR, Riphah International University until Apr 2019. Copying or posting is an infringement of copyright. [email protected] or 617.783.7860.

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WHAT HAPPENED

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It may be worthwhile for the instructor to know that the company could not manage the required working capital for the railways contract. Neither did the bankers ease the terms of fresh credit nor could the company realize the blocked funds. The company still struggles to finance its working capital requirements. SUGGESTED FURTHER READING

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No

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W. Baumol, 1952, “The Transaction’s Demand for Cash: an Inventory Theoretic Approach,” Quarterly Journal of Economics, 56, pp. 545-556. Martin Binks and Christine Ennew, “Growing Firms and the Credit Constraint,” Small Business Economics, 15:1, pp. 17-25. “Indian Chemical Industry: A Sector Study,” Export-Import Bank of India, Occasional Paper No. 117, March 2007, http://smallb.in/sites/default/files/knowledge_base/reports/IndianChemicalIndustry.pdf, accessed November 9, 2012. J. Herbert, S. Visscher, “Industry Practice Relating to Aggressive Conservative Working Capital Policies,” Journal of Financial and Strategic Decisions, 11:2, pp.11-12. I. Lazaridis and D. Tryfonidis, “Relationship Between Working Capital Management and Profitability of Listed Companies in the Athens Stock Exchange, Journal of Financial Management and Analysis, 2006, 19, pp. 26-25. M.S. Long, I.B. Malitz, and S.A. Ravid, “Trade Credit, Quality Guarantees, and Product Marketability, Financial Management, 1993, 22, pp. 117-124. J. Mcmenamin, Financial Management —An Introduction, Oxford University Press, New Delhi, 2000. N. Meade and F. Gormley, “The Utility of Cash Flow Forecasts in the Management of Corporate Cash Balances,” European Journal of Operational Research, 2006, 182:2, pp 85-86. The Environment (Protection) Act, 1986, Ministry of Environment and Forests, www.envfor.nic.in/legis/env/eprotect_act_1986.pdf.

This Teaching Note is authorized for use only by NAJAM SAHAR, Riphah International University until Apr 2019. Copying or posting is an infringement of copyright. [email protected] or 617.783.7860.