Working Capital Management

Working Capital Management
Krishnamachari Srinivasan

About the Author
Krishnamachari Srinivasan (Krish) is a Chartered and Cost Accountant from India. He has over 28 years of corporate experience with him and has held various positions as Finance Controller, CFO and VP Finance. He has had the opportunity to work with some of the best run organisations like Modi Xerox, Greaves Cotton, Stahl International and Bilcare to name a few. He has held senior positions at Division, Business Group and company levels and contributed to the growth of the organisations. His superiors reposed enormous confidence in his work and many of his colleagues gave him excellent support for him to go beyond the role of a Finance Head to become a partner in growing business. During his career, Krish realised the importance of managing working capital and focused on revamping the related processes from a complete business perspective. He lead several improvement projects involving employees from diverse culture and from across functions to draw up procedures that had the buy-in from all the concerned functions. Thanks to the cooperation from the finance team, and from across functions Krish helped in making significant improvements in managing working capital and won several recognitions from the managements.
He was very keen and particular in bringing awareness amongst employees from all the functions about how each of them can contribute in a small way to improving the operations and add to the bottom line of the company. In the process he aimed at bringing the functions together and work as a team. He was successful in transferring his skills and success to the organisations he worked with.
His ultimate goal is to work along with as many organisations as possible as a consultant to spread his knowledge. He is willing to help save dollars for the companies who are willing to use his services.
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Preface: In my nearly three decades of working with organisations in various industries one thing I noticed was that companies which are financially healthy had highly motivated employees who enjoyed working with the organisation. These companies had good cash flows, profits and were able to pay good bonuses to employees. Underlying these healthy results was a very efficient working capital management system which helped these companies avoid wastage on inventory obsolescence, bad debts and unnecessary interest costs paid to banks on working capital borrowings. While this being the case with well run companies, I came across companies which were poorly managing working capital had huge inventory of which a substantial portion was obsolete, large amounts of overdue debts and working capital facility used to the fullest limits with banks.
As a consequence finance managers spent maximum time on juggling payment priorities paying to vendors who shouted the most and payments for the remaining vendors were rationed depending on how much cash was available on hand. Purchasing department staff were always defensive and on back foot at the negotiation table with the vendors. Relationships between supply chain vs. finance and finance vs. marketing were never cordial. I noticed that cash flow statement was the most frequently produced item competing with the top selling products of the company. No commitments can ever be given and held under those ever changing cash flow situations caused by poor working capital management system.
In one of the companies Vendors started queuing up early in the morning every day even before the staff came to work only to get a commitment for payment for a portion of their long list of pending invoices. The buyers in the purchasing department could never challenge the price increases which invariably included some interest cost to cover the delays in payments. It was very difficult for me to change the mindsets of employees from all concerned functions and every one had their side of story to justify why they managed inventory or receivables and payables the way things were happening.
I noticed that awareness on the importance of good working capital management practices was lacking in companies of all sizes and across many industries. Many of these companies did not have a proper inventory strategy and the management was not driving home the importance of a good MRP plan. Many a times lack of a reliable sales forecast was noticed to be the beginning of most of the problems. Credit management merely existed on paper.
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Having worked with a variety of professionally managed MNCs and some poorly managed SMEs, I learnt what every company needs to do and SHOULD NOT do in managing working capital if they want to be profitable and have enough cash to pay vendors on time. With three decades of hands-on experience I decided to put my thoughts and experiences into a book form on how the components of working capital can be managed for the benefit of all employees in the company who can contribute to making working life much simpler.
I dedicate this book to all my colleagues in Sales & Marketing, Supply Chain, Production and Finance in various companies who were very cooperative in my journey aiming to bring an excellent working capital system in operation. During this journey I might have been firm and rigid on many occasions to make the system work to provide fruitful result over a period of time. I want to assure that such efforts were more objective and without any personal prejudice.
Thanks for taking time to read this book. You are most welcome to send in your comments and suggestions to improving this book via email to skchari58@gmail.com
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INDEX 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19. 20. 21. What is working capital What is Working capital cycle Funding working capital How to calculate working capital needs What are current assets What are current liabilities Inventory management Receivables management Payables management Role of Finance Dept Role of Supply Chain Dept Role of Sales & Marketing Role of Production Dept Management approach KPIs Bench marking Interest cost impact Creating awareness and removing myths Tools and key strategies Continuous improvement Conclusion
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1. What is Working Capital? The term Working Capital means the amount of funds required by a business to run their operations. The initial share capital infused by the owners is primarily for setting up the business entity and partly finance any plant & machinery etc. However, the business will need funds to buy raw material, manufacture the finished product or sell the traded goods as it is, pay for the operating expenses and for keeping stock of raw material and finished goods. The money required for actually making the business work is Working Capital. For a trader, money is required for purchase of goods for resale, towards cost of goods to be kept in stock, and for money blocked in giving credit for customers. These are partly financed by the credit given by the supplier. Very few traders work on back to back basis without any need for working capital. For manufacturers, the company will need money to buy raw material, pay for conversion costs, power, labour, packing material to manufacture the finished goods and subsequently pay to freight forwarders for dispatching the finished goods to customers. Money is also required to finance the credit period given to customers.
In summary, though a trader can commence business with a small sum of say $ 1000 to start his office, he will need money to buy the goods he wants to sell to make a profit. Similar is the case for a manufacturer, he will need money to buy raw material, convert the raw material into finished goods and finally give credit to the customer. Traditionally certain businesses are run on cash basis only like restaurants, caterers, hospital services etc. However, these entities also need working capital for buying the ingredients for making the food items, or keep the medicines ready for providing their respective services immediately on demand. The fact that the customers pay for the services immediately by cash can only help reduce the amount of working capital blocked in the business.
There is a common misunderstanding between capital and working capital. While it is argued that both are invested in the same business, capital is the initial sum that is invested to set up a business, whereas working capital is about the money that is required to run the business i.e., convert the cash into products and then convert it back to cash including the profits earned on the money input. For setting up a factory, capitals is required for purchasing the machinery, utilities, offices etc and also buy raw materials to convert them into finished goods. However, please note that the amount invested in the machinery and fixed assets is a sunk cost and is not converted into cash unless the owner decides to sell the facility to another person. Whereas money invested in procuring raw material is first converted into finished goods, when sold is converted into receivables and finally back to the form of cash as collections from customers. Page 6

2. What is Working Capital Cycle? Working Capital Cycle also known Cash Cycle is basically the cycle time taken for converting cash into raw material into finished goods into credit or cash sales into cash, ie Cash >> raw material >> finished goods >> trade receivables >> cash.
CASH CYCLE
Cash
Receivables
Creditors
Finished goods
Raw materials
In a typical business assuming that a trader has to keep 15 days of sales as stock in his warehouse and he gives 30 days credit to his customers, then his working capital cycle is 45 days if he bought his goods for resale on cash basis or the 45 days cycle is reduced by the credit days given by the supplier. Similarly for a manufacturer, if he keeps 30 days raw material in stock, takes 10 days to convert the raw material into finished goods, then keeps 10 days finished goods in stock and finally gives 45 days credit to his suppliers, the total working capital cycle will be (30 days of RM +10 days of WIP + 10 days of FG + 45 days credit to customers 30 days credit from suppliers) = 65 days working capital cycle. It is important for every business owner to keep his working capital cycle to the minimum by reviewing each of the components meticulously. A proper balanced view has to be taken to ensure that the business is not affected in any way in the form of not being able to service the customers on time due to low inventory. In some industries new market entrants simply follow the credit period offered by competitors so that the customer has all the terms and conditions common across his suppliers except for differences in price & quality. Page 7

It is important for every aspiring entrepreneur to have a complete understanding of capital and working capital requirements of the business. Working capital requirement can be determined with a complete understanding of the product, industry and the market segment in which the business is being set up. The starting point of estimating the working capital is a sales forecast giving the quantum of finished goods that is likely to be sold. Based on the sales forecast, use the products bill of material to explode the raw material requirement by each item. If the raw materials are available locally, please understand the lead time for the supplier to deliver the raw material as per your requirement and estimate the variations that may affect the demand and the supply capabilities of the vendor. Please find out the credit period offered by your vendors. If the raw materials are available from different sources, please determine the stock of raw material based on estimated consumption during the procurement lead time and please consider the longest lead time. The next step is to estimate the production lead time within the factory to convert the raw material into finished goods. Proper estimation of the manufacturing capabilities also needs to be evaluated.
After the goods are manufactured at our factory the time taken to reach the goods to the customer along with the Shipping lead times can be fairly estimated based on experience or a shipper can help provide inputs. Credit period offered to customers is set by the management. In a majority of the new businesses, the company follows the credit period offered by other competitors; say 60 days from invoice date or BL date as the case may be. The days between the ordering for raw material and the days on which the customer pays cash for the invoices will be the working capital cycle days and the amount blocked in inventory, finished goods and receivables is the working capital amount.
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3. Funding Working Capital: Every business needs some method of financing to run the business efficiently. Financing the working capital needs can be from own funds or in the alternative through borrowed funds. We all know that for a new business owner, getting a loan is very difficult for two reasons the first one is the lender will look for experience in the entrepreneur and secondly the terms & conditions of the loan. Even for an established business funding working capital comes at a cost and the lender will look for security in the form of a pledge of assets in favour of the lender. It is common that banks will finance the working capital gap of businesses provided the companies have some decent history of profitable business. In addition the banks will charge differential rate of interest and also ask for pledge of current and / or other fixed assets. The banks normally provide two types of working capital support - namely fund based and non-fund based support. Fund based support are in the form of providing an overdraft facility, cash credit facility, bill discounting, Trust Receipt, bridge financing, term loan etc where the banks provide cash support.
The other facility is the non-fund based where in the banker provides letter of credit, bank contract, bank guarantee, deferred payment guarantees etc. Some businessmen prefer buying in cash to get some price advantage and sell also on cash depending on the nature of the product. These business owners prefer fund based facility as there would be some time difference between paying for purchases and collecting from customers. Overdraft facility upto a maximum of a specified amount is sanctioned by the bank depending on the credit worthiness of the customer and according to the nature of business. Cash credit facility is worked out using a formula to work out the drawing power of the customer which depends on the composition of inventory, receivables and payables the customer has. Both overdraft and cash credit are charged for only to the extent the facility is used. However, in some cases a commitment charge is also levied if the facility is not utilised to the expected levels. Non-fund based facilities like letter of credit, bank guarantee or bank contract, deferred payment guarantees are sanctioned by the banks based on the customers requirement. In international trade, unless the seller and buyer have an existing commercial term, all suppliers insist on the buyer opening an irrevocable letter of credit through a bank of international repute. However, the seller may be willing to give some credit of say 60 or 90 days and some in cases insist on document against payment. The LC with credit period is called Usance LC while the LC insisting on payment is called Sight LC. This is an assured mode of payment for the supplier as the bank is a well known bank and secondly LC is also an irrevocable LC. Revocable or simple LCs are available but are seldom used. For long term contracts the service provider may be asked to provide a bank guarantee which is Page 9

basically an assurance from the bank that if the service provider defaults on any account, the beneficiary of the guarantee can invoke the guarantee to ask for the money from the bank. The bank shall not ask any questions and is bound to pay to the beneficiary the amount demanded (subject to a maximum of the guaranteed amount as specified in the bank guarantee). Bank contracts are also one form of a credit letter given by the banks but are not a guarantee. For providing these non-fund based limits to new customers, the banks may ask the customer to provide a margin money (ranging from 20% to a max of 100%) as deposit for the non-fund based limit sanctioned.
On the supply side, companies supply goods & services to customers on credit and have to wait until the customer pays to get the cash cycle closed. Bill discounting and factoring are ways through which the company can get immediate cash from the bank after reducing a small portion towards discounting interest. However, the banks may lay some restrictions depending on the customer and other risks involved. In bill discounting or factoring, the banker has recourse to the company just in case the customer does not pay the bills on time for any reason. Interest for any delay will also be charged. The bankers will however, will be happy to discount supplies made under a LC which gives assurance of payment on the due date. Interest rates for LC backed discounting will be lesser than the open credit bills. It is natural that most new businessmen will want to manage his business needs within the funds he is able to put in himself. There are two reasons for this approach, (a) he is probably not familiar with the facilities banks provide or (b) he is afraid that banks will charge very high rates of interest and hence should borrow to the minimum. However, if you approach the cost from the angle that the bank interests are tax deductible while interest cost saved through own funds will be taxed fully as it adds to the profits of the business. Post tax interest cost could be beneficial instead of ploughing own funds as the opportunity cost of own funds could be different. Hence please consult your business advisor for choosing your method of funding the working capital needs.
Apart from commercial banks there are other non-banking financial institutions which can help on bill discounting or factoring of invoices. Here again, these institutions will charge depending on their funds availability and market interest rates. There are various other options of raising funds on LCs given by your customer. These are useful for capital equipment manufacturers where they would need funds in advance to buy raw material and the manufacturing lead time is also high. Certain LCs allow amounts to be drawn in advance and in other cases financial institutions will come forward to support provided the LCs are negotiated through them. Page 10
Another form of financial support provided by banks are in the form of Trust Receipts where by the banks will pay to the vendors on the due dates and will take an undertaking from the company that they receive the materials on a Trust Receipt indicating that they are holders of the material as trustees. Banks and financial institutions have their own norms on fund and non-fund based facilities. The terms and conditions can also vary from customer to customer depending on the credit worthiness, risk profile, security offered and the volume of business. It may be borne in mind that businesses have collapsed due to shortage of working capital funds and there are equal numbers of cases where businesses have perished due to excess working capital investment causing the cash to be blocked at high interest costs. Disadvantages of poorly funded company can be in the form of loss of business and inability to participate in big business deals. Excess working capital investment in inventory leads to obsolescence, bad debts & other market risks. It is always advisable for the company to use a business advisor who can help in proper estimation of working capital needs and help in getting the most cost effective method of financing the needs.
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4. How to calculate your working capital needs Working capital requirement can be calculated in a simple manner by any business manager. However, one has to have a good understanding of the business and business priorities. Let us first start with identifying the components of working capital - (a) Inventory raw material, semi-finished goods and finished goods, (b) receivables and ( c) payables.
First, let us identify the methods to work out inventory needs. Assume for a moment that we are a chemicals manufacturing company and are selling the products in many parts of the world. The starting point is to prepare a reliable and achievable sales forecast by each Strategic Business Unit (SBU) and in as much possible detail - like by region, channel, packing and variants for the forthcoming year preferably by month. Kindly note that the inventory level can be only as accurate as the sales forecast on which the model is being built. If the industry is not a seasonal one, you can assume that the sales will be fairly even through the year. For each of the products using the Bill of Material (BOM), identify the raw material in kgs and group the requirement of all products by raw material name. Using the quantitative values in descending order choose the top 20 items to see if they cover 80% of the total quantity, which is more likely. If it did not, please take the items that cover 80% of the quantity and do a check for dollar value if the same 80% by value is covered (with a variation of +/- 5%). Now you can estimate the average consumption per month (quantity as well as by value). These items may have different supply lead times before they are available at your shop floor for use in production.
There are statistical models available for working out the safety stock for the raw materials depending on the ordering, production and shipment lead times for the goods to be available at the shop floor ready to use in production. Please take into account the ordering lot sizes and also the rejection history before finalising the safety stock of these raw materials.
The next step is for the management to decide on the stocking policies for raw material, semi-finished goods and finished goods. Semi-finished goods are primarily manufactured within the company with which the possibly of making multiple finished goods exists. These can also be purchased from external suppliers and in that case these become raw materials directly usable in production. However, some companies get these semi-finished products (or sub-assemblies in engineering industries) manufactured through sub-contractors. The company may decide on stock policies for each class of raw material, semi-finished and finished goods. Kindly note to avoid tendencies to over stock materials which could harm the Page 12

companys cash flow and also cost money in the form of interest cost and also in the form of potential obsolescence through loss of shelf life, technological redundancy etc. Once the critical inventory levels are finalised, convert them into value in dollars. Preferably keep a template of the various parameters used in determining the stock levels. All assumptions may be documented as these are useful for challenging at the next review. In the initial stages review the stock policies once a quarter so that you have the opportunity to adjust your inventory levels to align to business goals.
The next category is Receivables. Ideally, before commencing business every company need to have the credit policy written down so that all the sales people talk the same language in the market and do not use additional credit terms as the incentive to customers to get orders. A proper credit management procedure needs to be written up defining the different credit schemes for different products, markets and for customer segments. Secured terms like LC, bank guarantee, agents guarantee terms etc can be specified for new customers. Set credit limits for each customer and make sure that supplies beyond credit limits are not allowed without the subject being properly discussed with the marketing head. As the risk increases the subject should be handled with the head of the business unit before additional supplies to that customer can be made. Once the credit policy is in place, estimate the amount of outstanding at the end of each month for each region and then the total of the regions will be the total receivables of the company. It is important to have the info by region to review and implement control measures appropriately. If you have any estimation of the probable overdue outstanding as at the end of each month, please factor the same to work out the net receivables using the formula, opening receivables, add sales during the month, less expected collections (i.e. total actually falling due this month + last month overdue amounts unlikely to be collected before month end) will be amount of total receivables (due and not-due) as at the end of the month. For the purposes of budget or estimating working capital, please assume that 80% of the amounts falling due during the month will be collected and the balance 20% will be collected in the following month along with the 80% of the next month collections. For a new company, assuming the average credit period is 60 days, then the first two months will see no collections coming in. This is the amount that will be blocked in receivables as part of the working capital. The next critical component in working capital determination is the Vendor payables. The vendor payables reflect the amount due to be paid to vendors & service providers as at the end of each month / period. The credit allowed is interest free. As we all know the principles of accounting states that companies should recognise liabilities as and when the amount becomes legally payable to the supplier / service provider. In the case of goods supplied by Page 13

a vendor, the ownership of the goods pass on to the buyer as per the contractual supply terms - like FOB, Door delivery, CIF etc. For example, in a FOB supply, the ownership passes when the goods are put on board of a ship by the seller. The company should recognise the liability in its books immediately upon receiving information about the bill of lading which is conclusive proof of the goods put on board of a ship. For services provided, as soon as the work is completed, liability should be recognised in the books. Payments for the goods and services are determined by the purchase contracts and are to be paid on the due dates. The total amount of supplies and services provided but not yet paid as at the end of the period are reflected as current liabilities. As a recap, Working Capital requirement is determined by estimating the amount of inventory to be held to do business, the total amount of receivable from customers due to the credit period offered and by estimating the amount of current liabilities for purchases & services due to vendors based on the credit period negotiated from vendors.
Inventory & receivables are current assets and are together described as gross current assets and the current liabilities (liabilities payable within 12 months) will be gross current liabilities. The net of these two will be the net working capital, i.e. Gross Current assets (Inventory + Receivables) - Gross Current Liabilities (Liabilities for purchases & expenses). The word current used in Current Assets and Current Liabilities is basically that the asset is convertible into cash in 12 months or less and similarly current liabilities mean the amounts due to be paid to vendors and service providers within 12 months from the reporting date.
Amounts in US$ 000 April 2010 Inventory Receivables 120 80 May 2010 110 90 June 2010 140 110 March 2011 160 150
Gross Current Assets (A) Current Liabilities (B) Net Working Capital (A-B)
200 (75) 125
200 (85) 115
250 (105) 145
310 (135) 175
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5. What are Current Assets: Current assets are basically assets which are part of the trade the company is in and which are saleable within the next 12 months. Inventory & receivables are current assets and are together described as gross current assets. You may have noticed that auditors always look for ageing reports of both inventory and receivables to check if they can be converted into cash within the next 12 months under normal business circumstances. The idea basically is that due to ageing the sales realisation from these assets can diminish due to obsolescence or due to the product losing its potential for use in the trade. For example, chemicals can lose their shelf life and may not be able to fetch the same price as fresh material. Then the value of current asset need to be revised downward to the market price and in some cases to scrap value which may or may not fetch any price. In the case of chemicals the company may have to spend money to dispose such old stock to comply with environment control rules of the land. At that stage, they may not be current assets any more. Similarly in the case of receivables too, the money should be realised after normal credit period allowed. However, for some reason if the money still remains as a receivable, then the actual cause needs to be analysed. The customer may have held back payments due to commercial or technical disputes, or may be the customer has become insolvent & unable to pay the debt. Under such circumstances, the receivables amount shown under Current asset should be reduced to the true realisable value according to the circumstances. It may be noted that some of the inventory and the receivables may be less than 12 months old, but nevertheless they may have been impaired for reasons of losing shelf life or the customer who owes the money may have become insolvent.
There are also other reasons how some of the items though in the relevant trade may have to be declared as not current assets for reasons like the customer may have sold that line of business but the stocks remain with the company. In this case, the company will have very little chance of being able to convert the stock into cash as the business has ceased to exist. Similarly, some of the receivables are under a legal dispute and the case is pending to be finalised either way.
Cash and bank balances are also treated as current assets and but are not generally included as part of the working capital calculations. Security Deposits, rental deposits given, rental advances given etc are also current assets. However, for the purposes of working capital calculations, it will be good to consider only inventory, receivables and payables to arrive at the net working capital as other current assets are considered as non-trade current assets. Advances paid to vendors are to be included as part of working capital. Page 15
Bankers, lenders and auditors are particularly careful to understand what the current assets contain and how truly are they really current assets. Companies show high current assets in their balance sheets to give confidence to the bankers and lenders that their money is safe. It is not the quantity that is important here but the quality of the current assets as companies may have hesitation to clean up the inventory by removing non-moving or slow moving items for the fear that (a) the write-off could impinge on the profit & loss for the business for the year and (b) the lenders expect a good current ratio to be seen on the balance sheet. Current ratio is the ratio of gross current assets to gross current liabilities. Hence to keep the current ratio high companies tend to avoid cleaning up the slow and non-moving inventory. The bankers therefore ask for age-analysis of inventory and receivables to get confirmation from management that the old stocks and overdue receivables are in tact. Companies having a current ratio of 2:1 are said to be healthy. This means that the company has current assets twice the value of current liabilities that it has to meet. Bankers while sanctioning trade finance facilities demand that the borrower company provide statement of current assets and current liabilities along with cash flows on a periodic basis. This is mainly to ensure that the funds and facilities extended to the company are put to proper use. The bankers look for current ratio, liquid ratio, Acid Test ratio, inventory turnover ratio, receivables to turnover ratio, DSOs of inventory, receivables and how the net working capital has moved in comparison with sales on a quarter to quarter basis. If any abnormalities are noticed, the banks will call for explanations from the company on why inventory or receivables is being built up or why the ratios are not healthy. Some banks levy penal interest if the company does not maintain certain critical parameters as specified in the letter of offer.
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6. What are current liabilities: Current liabilities are the amounts the company is liable to pay within the next 12 months. These liabilities are part of the trade like amounts due for purchase of raw materials, goods purchased for resale etc. Similarly, amounts due for services provided like for example purchase of electric power, annual maintenance contract for machinery, security services, insurance for assets etc. These liabilities have to be recognised in the books immediately upon the goods and services have been purchased or availed. The suppliers and service providers do many a time give time (credit of 30 days) for making the payment. However, the company availing these services have to account for the amounts payable for the goods and services in their books as current liabilities immediately upon receipt of goods or services though the actual payment for the invoices could be after the credit period of say 30, 60 or 90 days. In many cases, particularly suppliers from overseas insist on letter of credit being opened from a bank of international repute in their favour for the value of goods to be supplied. The terms can be on FOB, CIF or door delivery basis. The ownership of the goods passes as per the terms of delivery and the liability is automatically created under commercial law.
It may be noted that liabilities for purchases need not be booked merely because the company has opened letter of credit in favour of the suppliers unless the goods have been physically dispatched by the suppliers in accordance with the LC conditions. Companies normally account for the goods in transit from the supplier location at the year end so that liabilities are recognised in the books as per accounting standards.
Similarly, salaries, rent, electricity consumption, lease rent, interest on loans are also liable to paid at the contracted periods (usually on a monthly or quarterly basis) and have to be recognised as current liabilities in the books of accounts. Taxes on property, income tax, withholding taxes, VAT, GST, deposits from third parties which are returnable in the next 12 months are also categorised under current liabilities. It may be noted that loan repayment instalments though of a capital in nature which are due in the next 12 months need to be recognised as current liabilities.
Every company should aim to have current assets more than the current liabilities indicating that they will be able to meet all their obligations in the next 12 months. For a business to be considered continuing and on-going, the net working capital should be always positive. A negative net working capital means that the company does not have enough cash on hand and even if all the current assets are converted into cash the obligations to pay vendors and Page 17

service providers will be unfulfilled. This is not a welcome sign and all stake holders will be very much concerned about the situation. The owners should immediately arrange for bringing in additional capital. Borrowing from external parties to make the net working capital positive is not a healthy sign and most lenders will be very apprehensive of financing such needs.
Companies while evaluating its different business groups normally consider current assets and current liabilities which are directly attributable for the specific business group. This approach is mainly to make the concerned business managers accountable for the amount of cash flow and profits generated from the respective business groups. It is very much possible that some business groups are not that much profit making or cash generating as that of other well run business groups. However, the company may still want to keep the relatively less profitable business only to provide a package of products to customers. This has a strategic element in running the company and therefore the ratios for each of these Business groups are set accordingly for like to like comparison.
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7. Inventory Management: This is one of the most important aspects of supply chain management in any company. It is in fact a large subject and can be dealt with as a separate topic for a full scale discussion. However, let us try and address inventory management as a sub-step in the working capital management process. You might have heard about the saying that Inventory is a necessary evil. The answer to this is in the affirmative, Yes, companies which hope to grow their business in trading or manufacturing need to hold inventory so that customer orders are serviced as soon as possible. Prompt deliveries do help retain customers and therefore the need to hold inventory of raw materials and finished goods to service the customers at once. You might have noticed that all super markets hold large quantum of consumer products apart from the quantities on display. Display shelves are replenished with items from the stock so that all customers are satisfied. There is always competition for shelf space at super markets to get the customers first attention. Organisations are puzzled and question themselves about how much inventory they should hold to satisfy customers.
Inventory management needs to begin with a quantitative evaluation of the stock on hand (except for companies which are just beginning). List out the stock on hand by item and while compiling the information please make sure to collect the date or month of manufacture of the item. Once the list is ready, get a practical sales forecast for the next three months from marketing in as much detail as possible. This forecast may be used to workout the raw material required to meet the forecasted sales quantity. Compare the stock on hand by each raw material to the raw material requirement to meet the sales forecast for the next three months. You might observe that there are items which are short and some items are in excess of the requirement causing an imbalance in the stock on hand. Our work begins here to make the inventory balanced and keep it optimal.
You can often hear sales & marketing people say that their market is really unpredictable and that they don't have a crystal ball to figure out accurately who will buy, how much and when. Yes, we all will agree with that statement, but that should not be a deterrent to avoid making a forecast based on information collected from customer interactions & meetings. The talent is in keeping the forecast minimally inaccurate and that the inaccuracies do not cause business losses. Sales forecasting is both a science and an art. Every sales person has to participate in the forecast preparation process and based on the interactions / discussions with the customer on a regular basis forecast of how much the customer would buy from our company can be estimated. Wherever there are changes and doubts that a sale may not fructify, the sales person can make adjustments to the forecast. Many Page 19

professionally managed companies which ultimately become market leaders help create and modify customer habits by analysing the needs of customers to make a meaningful sales forecast.
The sales forecast by product is then converted into a demand plan. The reason being the sales plan by customer can be for sub-optimal quantities from a production angle and therefore the demand planner in the company should aggregate the sales quantities by product and prepare a demand plan to plan for working out the production & purchase plans for each of the raw material using the standard Bill of Material quantities for each finished good. Demand management is the function of recognising all of the demand for the products that are required to support the market needs. Demand elements include customer orders, sister division requirements, samples, internal needs for making other intermediate products, interplant orders etc. The Supply chain manager can work out a material requirement plan on a rolling quarter basis and review the same every week for actual sales vs sales forecast so that necessary adjustments for over or under performance can be made in the ordering process. Normally, inventory gets built up by ordering per demand plan and because of reviewing only once every month when a new sales forecast is prepared. Sales & Marketing team need to provide heads up info to the operations team on any drop in sales vs plan or when any new order is likely to come up at short notice on a periodic basis (preferably weekly) so that raw material supplies can be adjusted accordingly. In the absence of either the timely corrective inputs from marketing or corrective adjustment from ordering side on time, two scenarios can take place in the form of either lost opportunity to sell or the company lands up with excessive inventory which may or may not move in the coming months. A proper sales and operations review procedure need to be drafted adopting the best practices and agreed by finance, sales, demand planner, purchasing team and production team. Frequency of this S&OP review is normally a monthly process. However, weekly short meetings are held between team members to take note of abnormalities and events that could affect the order fulfilment process. The team should be informed of any raw material supply issues, quality issues, changes in sales forecast, production related issues and the impact on keeping the delivery schedules as promised to the customers. To handle any mismatches in the supply chain, if management decisions on air freighting of raw material or sending finished goods to customers by air or deploying manpower on overtime work are to be taken, the S&OP team can put up the proposals to the management with related costs. Simultaneously efforts should be taken to avoid any repetition of such mismatches as additional costs and efforts are incurred in the process of ensuring smooth deliveries. Purchase department need to Page 20

coordinate with suppliers in either pushing out shipments or pulling shipments depending on the weekly review meeting with the S&OP team members. The Supply Chain manager or warehouse manager who is responsible for the warehouse need to make sure that all receipts and issues of raw materials & finished goods are accurately documented / accounted. This will help improve the stock accuracy to help the planning process and avoid creating stock out issues. It is possible that sometimes consumption of raw materials go off plan due to wastage above normal levels, demand in excess of forecast or due to the finished products not meeting the quality standards set by the company. Hence the purchasing team have to constantly monitor the consumption of raw material vs plan and readjust the schedule of deliveries from suppliers for various raw materials to make sure that production is smooth for meeting delivery commitments to customers.
At the end of each month please prepare age analysis of inventory based on the purchase or date of manufacture. Please concentrate on old stock even among fast moving items, like for example if you find from say July 2011 end stock a lot purchased in Jan 2011 is still remaining unsold while subsequently purchased stocks have been sold, then special efforts have to be taken to find out the reasons for the old stock. It could have been a mere omission to record a material movement, or may be the item is spoiled and not suitable for use in manufacture or even it could be a wrong entry in the system while the stock physically available is a fresh one. I have personally come across very interesting and informative reasons which reflect poor documentation or systemic errors. One has to make sure that the system is made fool proof and make sure that procedures are properly understood by all the members in the warehouse. If need be the warehouse manager should update the material issuance and receiving procedure incorporating the actions from these stock analysis. If proper reviews take place and stock count discrepancies are addressed on time, over a period of three to six months, inventory will be reduced to an optimum level while ensuring that the company is very flexible to respond to market demands.
While Inventory management is certainly a direct responsibility of the Supply Chain Manager, other functions like Marketing, production and Finance have an equal role to play in achieving the optimum working capital. If the sales forecast accuracy can be improved to a fluctuation band of only +/- 15%, I am sure the Supply Chain team can respond very well with good flexibility to improve their deliveries to customers. Similarly if production works as per the production plan by making sure that the consumption is per plan and that the finished Page 21

goods have the least number of quality issues, then the consumption part of the inventory management is taken care of. Rearranging production schedule due to machine down time or to optimise production efficiencies without proper input to the procurement team could affect consumption patterns causing stock out situations and delivery failures. Finance has a good role to play by being able to support the purchase team with the required trade finance facilities (like Letters of credit) and also with prompt payment to vendors by closely monitoring the cash flows.
In addition to managing the accuracy of the stock records, the purchasing team needs to have regular interaction with the key suppliers to have a push / pull approach of drawing inventory according to requirements. This approach will help the company to balance inventory and avoid excess / shortage. Wherever, a company has multi-production units, a centralised approach to buying can help to keep safety stock and optimise inventory levels. Safety stock is good to keep to avoid unexpected increase in consumption or unexpected delays in the supplies reaching the factory. While each company may approach different methods to determine safety stock, the following formula can help you to fix one for your company Safety stock level = Maximum consumption per week in kgs or units x (maximum procurement lead time in weeks - average procurement lead time in weeks)
The above mentioned formula for safety stock can help you maintain continuity in production without a stock out situation as it assumes a sudden increase in consumption pattern and a sudden increase in the lead time to bring the material for production. It may be noted that the effectiveness of a good safety stock measure can be best achieved when the sales forecasting is in reasonably proper shape. Higher the fluctuations in sales forecast can lead to sudden surge in demand leading to peaks and / or lows in sales orders. This can lead to either stock out situations or excessive inventory. Safety stock formula based on such peak consumptions can give abnormal numbers and the effectiveness will be completely lost. Hence, good sales forecast, stock accuracy, safety stock and ordering discipline are all essential parts of a good inventory management system.
The purchasing or Supply chain manager can consider arriving at a re-order level for each of the items in order to automate the ordering process and manage only exceptions. Reorder level is the level at which the purchasing department need to place order with the supplier. This can vary for each item depending on the consumption pattern and the supply lead time for the product per supplier. The following formula can help arriving at the re-order level. Page 22
Re-order level = Maximum consumption per day x lead time in No. of working days
In the above diagram you can notice that the stocks in the beginning was higher than the reorder level but when the line starts moving down, at the point of re-order level the purchasing department sends the order to supplier. During the delivery time consumption of material continues and in this case at a faster pace which could have lead to stock out had we not had the safety stock supporting us. When the material is received next day the stock level moves up above the reorder level and then the process takes over. If at the point of ordering due to a knee jerk reaction if the purchasing department orders a larger quantity than normal, then the stock level upon receipt would have been much higher than normal and immediately the supplier should be informed to push the next dispatch by a week or as required.
Inventory management process is not complete without a mention about physical stock verifications and the importance / need for physical verification procedure. We talked about a while ago about the need for ensuring that the inventory records are up-to-date and accurately recorded. Physical stock verification is important for a couple of reasons, first is to make sure that the inventory on paper (or per computer) is really available and is also in good shape for use in production or for sale. Companies conduct stock verification
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periodically as part of their internal control procedure and also to give confidence to the auditors that the company has a system to verify stock commensurate with the size of operations and complexity of business. If the number of items is not many say less than 200, then apart from annual 100% stock verification, the companies conduct 100% verification every quarter. Companies which have more than 200 item codes go for cycle count or perpetual inventory verification by categorising items based on value. Class A items are expensive being the top 20% by value, Class B to be medium covering the next 60% by value and Class C to be low value items covering the last 20% by value. Class A items are physically verified every month, B items once in a quarter and Class C items once a year. The frequency and class distributions differ from company to company but follow the normal ABC principle.
With a good ERP system and well trained staff maintaining high accuracy levels are a norm. However, due to the accumulated minor variations in receipts and issues the physical stock can be different from book stock. For example in a chemical manufacturing unit, most of the times the receipts are recorded based on the weights declared on the packages though random checks are done make sure that the declarations are correct. The weighing instruments at the supplier point and the receiving end could have calibration differences. Also when chemicals are issued for production, spillages and powder fly can cause differences in stock.
At the end of each stock take, the warehouse manager may analyse the differences and get management approval to adjust the books to reflect physical availability of material. Companies have levels of authority to make the adjustments for write-off and for monitoring the cumulative differences in a year. Necessary process improvements can be made to ensure that the physical losses and write-off are minimised.
In Engineering companies and automobile component manufacturing companies differences in physical stock are seriously viewed for investigation. Pilferage and stock thefts could come to light for taking appropriate corrective action. It is important to have proper controls for stock verifications and authorisations for write-off so that pilferage are minimised absolutely. It is generally observed that pilferage starts in a small way and once the route is tested, bigger lots go out particularly costly items which are easily marketable.
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8. Receivables Management
Receivables from customers are another large component in working capital that needs management attention. Every industry has their peculiar demands and expectations for credit to pay for sales. Credit period was probably originally thought of a business support to the buyer so that he is able to sell the product to the end user as it is or to provide for the time to convert the raw material into a finished good for sales. Later additional credit period was used as a sales incentive to win over competition by new entrants. In a perfectly competitive market where there are innumerable suppliers of products of same or similar quality, new entrants use lower price & extra credit period to woo customers. Buyers who have a constant appetite for cash look for vulnerable suppliers who can give extra credit and even existing suppliers fear losing customers if chased for payment. Monopoly position holders in every industry have their firm say in credit and in many cases you can see they collecting advance before the sale is done. Some segments in specific industries have for a long time a custom of doing business only on cash or payment by other means but immediately. Food industry particularly restaurants do not give credit while frozen food suppliers have to give credit. Hence every company needs to have a credit policy before entering into the market. Once the policy is firmed up have a proper system in place to implement it and have a procedure written up for consistency. The business owner can review and make changes to the procedure as his position & policy changes. This helps the staff on the field to communicate appropriately to the customers.
Let us discuss briefly about making a procedure within the broad credit policy framework. First evaluate whether the same policy can work in all the markets, hence the procedure can state the markets which need to be treated as an exception. For example some companies deal with customers from politically unstable countries only on an irrevocable letter of credit from a bank of international repute and may insist on the LC being opened from another safer country. For some other countries, they can insist on 100% advance due to high credit risks. When these exceptions are identified, the rest will fall into a major normal class. In this category, the company may go in for a customer segmentation like individual businessmen, big corporate, private limited companies and partnership firms. Credit limits for each of the customers may be worked out using a formula to determine the value based on (credit period + 30 days) x average sales per month or where the customer category is either having a long term relationship, or being a company with good credit rating, the credit limit can be (credit period + 90 days) x average sales per month. Each year, the marketing and finance head have to review the credit limits based on the actual data of payments from the
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customers to revise the limit upward or downward. Another reason could be that the average sales per month may have gone up from the previous year. All new customers may be given only 30 days credit with a credit limit of maximum 45 days average projected sales value. Once the limits are set in consultation with the marketing team, the same can be added to the computer system for automated credit controls. Credit blocks can be activated based on either the financial value being reached with a particular supply or when the outstanding amount for any invoice is 10 or 15 days past the due date. The credit block by the system need to be informed to the concerned sales manager who may in consultation with the finance manager approve to release the blocked order on a one-off basis or recommend for increasing the credit limit. The sales managers and the finance manager have to convince themselves that the money is safe and will be received shortly. It is good to record the reasons for approving the blocked sale so that the system can be more self reliant by providing a small tolerance of 5% over the credit limit approved and either the sales manager or finance manager in individual capacity can release the order. Some companies go in for a confidential credit bureau report for all new customers and for credit limits above say US$ 300k to make sure that there are no subjective calls taken.
It is well understood by all that a sale is not complete until the money is received. Hence the primary responsibility for collections is automatically on the sales person who has constant interaction with the customer for order taking, new product development & launch, growing business etc. Many a times, when a new order is being negotiated the sales person may have a tendency to go slow on pushing the customer for the overdue collections. The ultimate responsibility is on the sales person. The sales manager may implement appropriate KRAs, KPIs and incentive schemes to make the collections come in on time.
Finance team have to cooperate with the sales team with daily updates on billing and collections. At the end of each month an ageing report of receivables by each region and a statement of account for each customer showing the total and overdue outstanding needs to be provided. This will help the sales person to schedule his customer visits and also manage new order vs collection priorities. Well managed companies set collection targets for the sales managers to collect 100% of the overdue outstanding from previous month and 75% of the current month dues. The parameters can vary from company to company or region to region. Each week the finance team can provide the actual vs plan collections to help the sales managers to follow up. At the end of the month a full list of collections vs plan by customer may be provided by each sales person to give them the overdue outstanding status. Along with this the updated receivables ageing report need to be provided. It has to
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be understood that collections need to be constantly monitored and not on a sporadic basis. Many finance controllers will confirm that collections do not come in evenly during the month and the pattern is skewed towards the end of the month along with some spillover to the first week of the following month. This is an indication that the sales team start pushing for collections only after the third week of the month and therefore the skewness.
Finance team normally prepare a quarterly rolling cash flow forecast each month to make sure that the inflows and outflows are properly matched. The cash flow forecast is normally based on the expected collection dates per customer based on historical payment record. These weekly inflows mostly do not match with the outflows for vendors, statutory commitments, salary and standard payments. As a result extra effort is required to make the force fit by pushing for collections on the due dates. It is therefore important that the sales team and finance work closely to have focus on exceptions while gently reminding the regular paymasters with the statement of account each month. The finance and marketing teams have to have perfect communication to make the system work. Tightening the credit management system happens when the collections do not come in on time and majority of time is spent on following up with customers who constantly keep revising their promised dates. I am sure many of us have the experience to write a never ending list of excuses given by customers for delays in payment. Hence, in order to balance between business growth and getting collections in, the sales managers have to communicate strongly to the bad paymasters and use the finance team to support in following up to make the customers to pay. Dunning letters are sent after one month of non-payment after due date and legal notice can be sent after three strong followup actions jointly with finance. These have to be clearly stated in the credit procedure so that all company staff have clarity on how the management views collections as a critical activity. If agents are involved in the sales transaction, the agent will not get his commission unless the customer pays and will get lesser commission from normal if the delays are beyond 30 days and not exceeding 60 days after due date. After 60 days from due date, the agent will earn no commission and legal action can be taken against the customer after the due communication in this regard.
While reviewing the annual sales performance of sales team members, contribution earned by customer need to be reduced for the credit period given at say 0.5% per 30 days and where delays beyond 30 days after due date have been noted, 2% penalty points per month are charged to work out the contribution per customer. The sales managers can then work out their strategies to either walk away from such bad paymasters or have alternate Page 27

arrangements for timely payment. We have noticed in the working capital cycle or cash cycle as is also known as, that collection is a key factor to achieve efficiency of operations and to make payment to our suppliers on time. As a result of poor collections if the company delays payments to its vendors, then the bad credit rating will affect the companys ability to negotiate better terms with bankers and suppliers.
While making all good efforts to collect the dues from customers, sales team members often face customer allegations about quality issues and insist on credit notes being issued before payment can be organised. This requires the company to have a good quality management system in place and also a good complaint resolution system. As soon as complaints are acknowledged as a valid claim, Finance department need to support the marketing team by issuing credit notes on a timely basis. A proper credit note issuance system and procedure has to be in place as part of the complaint handling system. Finance team may send monthly statement of accounts to each customer and get confirmation of balance each year in writing. If statement of accounts is received from customers then finance has to arrange for reconciling the amounts indicated as due with the companys books. The accounts receivables assistant have to be alert by bringing to the notice of the Finance and Sales manager if a customer skips paying for an invoice to clear subsequent invoices. The older the issues remain unreconciled, the deeper the problem will be and will take twice the time to resolve issues. Wherever sales are made against letters of credit, finance team has to make sure that the documents are correctly submitted to the bank per the Letter of credit and track the collections. Many a times charges are deducted for discrepancies in documentation and the bank will delay paying the amounts. To avoid these discrepancies, the concerned staffs have to be trained in LC documentation. Letters of credit received from customers have to be scrutinised by trained staff as soon as they are received and highlight any need for amendments like the value of LC, conditions which are not standard etc. Amount spent on training will be much less compared to the bank charges incurred for companies handling large number of letters of credit. Smaller the invoice values, the larger will be the impact as the discrepancy charges are for per document irrespective of the value of the transaction.
Overall, management of receivables is a coordinated effort between sales and finance teams supporting each other with timely information. Companies which are successful in maintaining a low DSO (Days of sales outstanding) will confirm that prompt payment or delayed payment from customers are a habit entirely based on the follow up methods the company adopts. In one particular industry where credit period normally ranges between 90 Page 28

and 120 days, a MNC entered the market and appointed distributors. The distributors demanded that they be given 90 days like other competitors did. However, the company management was firm in saying that a maximum of 60 days only will be given and that financing or managing the end customer credit is left to the distributors to manage. Differential pricing for customers asking for longer credit was allowed but the company stated that the products should not be over priced to lose sales orders. The company decided to focus on their core strength of manufacturing high international quality products and provided good after sales support. A few months later the competitors started wondering if they also could have followed this approach. Hence a good credit policy, credit management procedure and great team effort between sales & finance along with a focused management will help greatly in making sure that the receivables are in proper shape. Growing business by giving additional credit may give you satisfaction but the company will start bleeding due to longer cash cycle. A good balance between growth and risk management are therefore necessary. I would like to add a few more words for the Finance team in making sure that the reports are kept clean by regular reconciliations and by constantly reviewing items if they move from one column to another in the AR ageing report. Auditors will also insist on making provisions for doubtful debts if they see that some invoices are unpaid for more than 180 days from due date. Finance manager and sales manager have to evaluate each customer for long overdues and help resolve issues amicably. Please visit the customers together with the sales manager to have a face to face discussion and understand the factual reasons for nonpayment. Evaluate the situation and do not hesitate to take legal action if the situation warrants.
In my several years of managing Finance departments I have noticed that due to poor relationship between Finance & Sales staff collections are not correctly adjusted against the invoices for which the customer has paid. This happens due to bank transfers and the Accounts staffs credit the amount as a lump sum in the customer account. Over a period of time this gets accumulated and at one point of time when the concerned employee leaves the company the new incumbent will be left with a lot of mess to clean up. Depending on the volume of such messy record keeping neither the Finance Manager, nor the Sales Manager are able to state if their information is in proper shape. Customers have records of payments and dismiss all follow up exercises by the new staff. It is the responsibility of the Finance Manager to make sure that the accounting records are kept in order and follow up on time and every time with the sales manager for the details of invoices settled in a bank credit.
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Every sales manager and Finance manager is aware of the fact that not all customers are organised and have the cash flow to pay our dues on time without follow up. Hence have a strategy for managing the receivables for each customer. Where sales agents are appointed go by the same route for collections as well and make the agents accountable for collections. Customers who are known to pay without follow up need not be disturbed and monthly account statements should be enough. The head of marketing team may like to send a letter of appreciation at the year end for giving business and paying promptly. There are other customers who pay only after receiving a couple of reminders can be sent reminder emails one week before the due dates or may be have an arrangement to get paid once in 15 days for the invoices due till that date. The AR assistant can have a direct contact person in the customer company to send statement of accounts and reminders.
Overall, have a strategy for following up with each customer, implement the credit policy and procedure in spirit, do not hesitate to review and take a call on exceptions, be considerate to customers if they come up with a problem, but be focused on when you will get the money. Any deficiency in this area directly leads to cash flow problems and finally in writing off of unrecoverable receivables.
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9. Payables Management: Management of creditors or payables is important from a credit rating view point. All suppliers are important and have to be paid on the agreed due dates. If for any reason the company foresees a delay beyond a few days, it is better to inform the supplier in advance and give a commitment about when the payment can be expected by them. Once a date is committed kindly make the payment without fail and vendors will respect the relationship. At the price negotiation discussion, payment history is one standard topic and companies failing to honour payment commitments lose out on pricing terms. Vendors may not prefer doing business with chronic bad paymasters.
Finance department may make sure that the invoices from suppliers are promptly accounted for and highlight to the purchasing department of any discrepancies compared to the PO terms. Modern day ERP systems make a GRN provision (Goods Received Note provision) for payment to vendors immediately upon materials being received at stores and give credit to vendors upon invoice being accounted. A constant review of the GRN provision list would indicate that invoices have either not been received or not accounted for in the vendor account. As a result of this, the balances as per vendor books and the companys books will differ. The vendor may be chasing for payment of a probably misplaced invoice which has not been accounted for in our books and could lead to unwanted discussions. Hence a regular review of the GRN provision account and reconciliation of vendor accounts is a must. The GRN account can at best have provision for receipts of material for the immediately preceding 15 days and certainly not anything more than 30 days. If any invoice is found with a different rate as against the PO rate, the matter should be immediately raised with the purchasing team to resolve it. Similarly, if there are rejections for which the vendor is expected to either give free replacement or a credit note, then also the subject needs to be resolved as soon as possible by the purchasing team. A coordinated effort between purchase and finance can certainly help.
It may be noted that most of the times one time purchases and emergency purchases end up with poor documentation causing enormous pain to the supplier. Finance may not be even aware of the purchase of material and vendor may be chasing the wrong person in the company for payment. Engineering / Purchase department buy spare part purchases normally come across such issues. Finance should draft a procedure for such spot purchases with or without PO and monitor vendor dues. It is quite possible that the companys cash flow may have to be revised to provide for such adhoc payments and therefore kindly give a commitment for payment only if the company is sure of honouring on Page 31

the due date. If no due date can be immediately given, please request for a couple of days time from vendor and in the meanwhile the matter should be internally raised to higher levels for resolution.
Purchasing department may work out a chart to indicate the mix of vendors in different credit days and provide the information to finance with indicative average purchase values per month. This will help Finance to plan for outflows by each week in the month and match the inflows accordingly. An efficient purchasing team can trade off on credit terms vs pricing for companys benefit, however, the same need to be in line with the companys cash flow situation. A matrix by credit terms and value of purchase per month can highlight the efficiency of purchasing function. This can also be a good input for finance and marketing to work on for improving their efficiency to manage working capital. It is a generally known and accepted principle that if a company faces any cash flow issue, the non-key open vendors like AMC contractors, packing material suppliers, freight forwarders, printing and stationery suppliers etc are the worst affected as payments are delayed. Key suppliers and secured term suppliers (under LC) get their payments on time. However, the message about payment delays spread very fast in the market among the nonkey suppliers. Vendors like to work with companies which are reliable and keep their promises irrespective of how big the businesses are.
Finance department may prepare an ageing report of the vendor payables at the end of each month and plan for their cash flow to meet the overdue payments. If at any point of time the cash flow forecast indicates a shortfall, a proactive discussion with the purchasing team can help in managing the vendor payments while simultaneous action with sales team is required for stepping up efforts on collections to bridge the gap.
Finance manager may allocate some funds to clear the payments on priority to vendors who have higher overdue in terms of days and give them the comfort by bringing the overdue to reasonable levels. Vendors are normally very cooperative as they need us so much as we need them. After the routine follow up from the vendors marketing team, their senior management may go over to have a meeting with the company requesting for payment. Depending on the situation they may evaluate and agree for a schedule of payment. As long as the company holds the payment schedule as committed the vendors are happy to work together and only on defaults or if they find the companys intentions are different, legal action may be initiated. The art of managing payables lies in making sure that no pain is endured by the supplier in extending credit or doing business with the company. Page 32

There have been times when vendors supported the company by agreeing to provide onetime extra credit for the company may have some bank mandates to meet. They always look for long term relationship and care should be taken not to take undue advantage of the leniency. It is important to develop a partnership in growth approach with the vendors and treat them with respect. Your companys business growth is first supported by willing suppliers who offer not only quality products at competitive prices but also give you the best credit period to pay with an objective to be your long time trusted vendor. Vendors who aggressively market and lure you underpricing other competitors and give you additional credit need to be properly evaluated for consistency. Focus first on quality of products and then on the commercial terms. There is no point in buying poor quality or unwanted materials at a cheaper price.
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10. Role of Finance Department:
Many a readers of this book may view that it is the prime responsibility of Finance to manage working capital. Yes, it is true but Finance alone cannot make sure that the working capital cycle is efficient enough. Having said that, there are many areas where Finance can play a vital role in having an efficient working capital management system. This comes with a positive attitude and a good understanding of the business among all the key members of the management. Finance can play a vital role in setting up the credit policy, formulating the credit procedure, having a good credit management system, ensuring that the credit note issuance system is efficient, understanding the financial strength of the top 20% of customers who contribute to 80% of the business & EBITDA etc. Finance needs to ensure that all records are properly updated on time, maintaining a clean statement of account, communicate regularly to sales team on collections, provide AR ageing report by customer & region at the end of each month to make the administrative job of the sales person easy on collecting the overdue. Inaccurate statements and incomplete information provided to the sales person can put him in embarrassing situations when the customer is asked for the overdue which are not really overdue or they have already paid for the invoice.
Finance department performs the role of an activity hub in the company. Everything starts with money and ends with money. As a result there is a lot of expectation and accountability for being a support function. In most organisations finance team members are not in the best of relations as the approach tends to be more of a controlling nature than being an enabling function. Every function is doing their best and have their priorities. Hence treat each other with respect and work in a completely professional manner without any emotion. If discussions take place only when issues crop up then the result will not be in the best interest of the company as a whole. Neither of the functions will be right nor wrong. Hence a proper understanding of the situation on hand and sincere efforts to resolve the issue is required. Commitments made have to be fulfilled on time without followup. I would recommend that one can take lot of time at the discussion table to argue and present your view point, but once a consensus is reached whole hearted support need to be provided. This is true for all functions and a business outlook is more important than the rule book. If you take authority and are ready to share responsibility / accountability, management will certainly support the functional head and believe me such leaders are much sought after by managements.
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Similarly, support of Finance on inventory management can come from setting up monitoring mechanisms for stock levels and supporting the purchasing department with prompt PO releases, LC opening etc in order to get the raw material in time and at the same time if in the opinion of the finance manager that the purchase need not be made the same may be discussed seeking clarification. This will enable controlling inventory more on a real time basis than after the event has happened. Finance being the coordinators with auditors need to take active part in the stock verification process on a monthly basis and during the annual stock take period. All the discrepancies need to be analysed in an objective manner and help in fixing any control issues that may come up during the analysis. The mere fact that another department is actively taking part in the stock verification process will deter any possible pilferage.
In the management of creditors and payables, the role of Finance is very critical starting from monitoring release of purchase orders, taking part in price negotiations and tenders and auditing invoices where variations are observed compared to previous purchase rates. This participation will help them in analysing all price variances vs budget and previous year. All cash purchases and emergency purchases need to be closely monitored to explore possibilities of bringing them into a regular purchasing process.
At the end of each month and also on demand, the Finance team may be expected to produce an Accounts Payable ageing report showing dues and overdue. This information will be useful in proper allocation of funds to pay the vendors on time as per the contracted payment terms. Periodic reconciliations of outstanding with the suppliers statement have to be arranged for and claims be verified. Large and abnormal differences between the companys books and vendors claims need to be addressed on priority to avoid any unpleasant action and also to make sure that the liabilities are properly accounted for.
In many a companies, Finance has to lead a role to create awareness of working capital management and benefits of a short cash cycle. While the vendors may be expecting their payments on time, our customers may be stretching their payments causing great strain on the cash flow management of a company. It may be difficult to explain to vendors about the difficulties faced in receivables management and supportive vendors should not be punished because of the companys inability to collect from customers on time.
The role of Finance is very important in ensuring that there is no revenue leakage. A seasoned finance manager will be able to analyse the variations and pick out the loopholes Page 35

in the billing system. This will help the company to account for the sales and follow up for the collections on time. Similarly preparation of accounts receivables statements and persevering follow-up for collections will help the company manage its cash cycle well.
Since Finance has a role to play in all the elements of working capital, the Finance Manager has to have a holistic picture about the way in which the companys working capital situation remains. Constant efforts in making improvements in processes with the help of the respective functional heads like Sales & Marketing for Receivables management and Supply Chain Head on inventory management and vendor payables are essential. This continuous effort has helped many a companies achieve an inventory turnover ratio of 12 and even more. Without much delay start measuring the current situation on DSO of receivables, inventory turnover ratio and Vendor payable as days of purchases. Set achievable but stretched targets for each of the components and lead improvement programs for making contributions to the companys performance. Every company may have their own reasons for the current level of working capital situation. However, for making improvements, select the best performers in the respective industry and benchmark the measurements for the company to start to set Key Performance Indicators for the respective functions to work on.
In order to achieve improvements in the performance measures of elements of working capital you may use the following steps
a. Measure the current level of DSO / Inventory ratio / Days of payables b. Bench mark with the best in the industry. If the gap is too wide, set steps to reach the goal c. Identify the gap between the current situation and the target d. Analyse the gap in as much detail to pin point the various areas of variance e. Generate potential solutions for each of the variations observed f. Select the solution to implement g. Monitor the actions and initiatives to see if the desired results are being achieved. h. Follow PDCA (Plan - Do - Check - Act) to work on the set objectives.
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11. Role of Supply Chain Department
The role of Supply Chain Department is very vital in the management of inventory and vendor payables. Physical Inventory build up is the result while the processes that lead to this result are actual purchasing, consumption (production), and dispatches as per and Vs a plan. At the outset, assuming we are discussing about a new manufacturing organisation, let us first discuss the inventory policy in which the Supply Chain Manager has a key role to play. Let us assume that the company buys its raw materials from overseas and the manufacturers of raw material need two weeks of manufacturing and freight forwarding lead time to put the material on a ship and a normal transport lead time including inland transport is another two weeks. In all any material ordered today will take totally four weeks to be available for production. Another assumption we can make is that all goods are manufactured as per customer order in a maximum of ten days from the date of receipt of purchase order including a three day shipping lead time. The inventory policy may reflect a four week reorder level including a one week safety stock of raw materials and the company may consider having finished goods stock of 10 days so that customer orders are serviced immediately. This inventory policy is based on assuming that sales are normally as per plan. If the variations between sales plan and actual are historically in the range of +/- 25%, finished goods inventory can be increased by three more days of stock. Once this inventory policy is in place, the company may start using a weekly Material Requirement Plan which is based on the sales performance of the previous week vs plan. If the sales has been better than plan, then the vendor may be instructed to dispatch additional quantities to top up the depletion in raw material. In case the sales have been below plan then the vendor may be requested to defer the dispatches.
The Supply Chain Manager need to have constant interaction with the production team and the sales team to understand the importance of having a more accurate sales forecast / plan if they want to help in reducing inventory. Similarly the purchasing team can interact with the suppliers to reduce the production or shipment lead times. Automobile industry has some of the best innovated supply chain arrangements like the suppliers are provided a warehouse space just next to the auto manufacturer to keep their inventory and the automobile manufacturer draws material on a daily basis as required by the shop floor or for kanban system of topping up the stock on the shop floor. Initiatives of any sort to reduce either lead times or reduce inventory holding are of great help to the organisation. Similarly, every small percentage of improvement in the sales forecast accuracy and efforts to reduce the procurement lead times can help reduce inventory. On another subject, the supply chain
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manager can also discuss with the vendors to see the possibilities of standardising credit period without compromising on the price and quality of the raw material. Let me address one topic where differences of opinion among department heads come into play in every organisation. We all are aware that each function in the company has a view point and may or may not match with one another. However, as the Head of Supply Chain it is the responsibility of the department to make sure that the customer commitments are honoured on time and all internal issues are handled in such a way to make the commitments work. Hence a very proactive approach to solving internal problems is required. At the time of reviewing the demand plan, if you notice that there are sudden surges in sales of some of the products then please discuss with the sales & marketing team to understand the reasons for such spikes and cross check with the vendors if the raw materials can be made available in time for committing deliveries. In case of some expected delays, alternative vendors need to be approached or air lifting of raw material can be another option or reverting back to customer if they can help providing some extra time. Similarly making sure that vendors are paid on time is also the prime responsibility of supply chain manager though it is the responsibility of Finance department to pay as per agreed credit terms. In many organisations of small, medium and large size in that order, there is always a cash flow gap that needs to be bridged and vendors with open credit terms get the first hit. Most organisations will be willing to support accepting minor delays of a couple of days, but consistent delays month after month will not be accepted. Either the suppliers may start building interest cost in their pricing or simply suspend further supplies. Both these actions will affect the company & will affect the KRA of the Supply chain team. Finance department cannot make payments without the collections coming in on time and ultimately the Supply Chain Manager has to go and convince the supplier to bear with the delays. Even with the limited cash available, the decision to pay which vendor and how much to pay will be better managed by the SCM head.
Please always challenge the current level of inventory to see how and where the processes can be improved to deliver better with lesser inventory. For example, if the inventory is analysed for slow and non-moving stock then actions can be initiated to liquidate the identified inventory at the earliest by targeting customers for those products or by selling at a special discounted price to incentivize customers to buy. Another way is to find out from the stock of fast moving items the number of months of future sales in stock. Let us take for example that 10 items are in stock for next 90-100 days. As these items are fast moving please find out the variations between the average sales to peak actual sales. If the volatility is high, then work out with marketing the real projection for the next 30 or max 45 days and Page 38

stop releasing further purchase orders for these items until the stock level comes down to 45 days sales. Thereafter, the orders may be released to ensure that the receipts per week are just enough to replace the consumed material. The lesser the amount of money we block in inventory (and working capital), the greater will be our cash efficiency and our flexibility.
Inventory management is a daily exercise and should not be left only to month end or year end. Many MNCs give importance for inventory accuracy not only the right quantity as per books but also the right location as stated in the stock ledger. I have personally worked with a very efficient lady Warehouse Manager who used to go around the various bays in the multiple stock points to check if the concerned stores staff follow the Standard Operating Procedures properly (particularly issuing on FIFO basis). She was also extremely hands-on with SAP on generating inward and issue entries, making standard & adhoc reports as required by the management. As a result of her own commitment and knowledge of best warehousing practices she was well recognised by the management for maintaining high standards of inventory accuracy for several years.
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12. Role of Sales & Marketing : Sales & Marketing are the bread winners of a company and play a vital role in the existence & growth of any organisation. Their ability to think on their feet in the market, ability to position products and create customer habits gives them a niche position in strategic thinking in a competitive world. We all know the importance of a good sales forecast and the great inputs of the marketing team as to what will sell, when and where. However, the sales & marketing team have not fully recognised their ability to say how much will be sold each month and are reluctant to give a forecast that is fairly accurate. One can often hear from the sales team that they are not sooth Sayers nor have a crystal ball to exactly predict how much and what the customers will buy in the coming months. Yes, I fully endorse that they do not have magical powers to predict with +/- 2% accuracy. However, they can provide a sales forecast with +/- 15% or max 20% accuracy to the operations team who are there to make the company deliver the customer needs and are the backbone of the marketing team in delivery the products as promised. One of the main reasons for companies having huge inventory of slow and non-moving inventory is the sales forecast accuracy being far from normal (+/- 20%). Operations teams do not second guess the forecast numbers given by marketing and therefore end up buying the raw materials as required to meet the forecast sales plan If the actual sales is higher than plan, then there could be loss of sales or a stock out situation can arise resulting in extra cost being incurred to make sure that customer orders are serviced on time. On the other hand, if the actual sales is less than plan, then stock gets built up unnecessarily. The excess stock could turn into slow or non-moving stock causing loss to the business.
Hence, it is important that Sales team members have a proper system to make the forecast and alert the operations team for major changes in the numbers. A close coordination between the two teams is very vital for the company to achieve excellence in business performance. Having said that, in order to achieve better forecast accuracy I strongly feel that amongst the sales incentive parameters, there should be one added element which will be a product of sales performance vs. budget / plan multiplied by a factor of forecast accuracy %. It is possible that the budget numbers could be set low but there are review mechanisms by the company CEO and Boards to get some realistic number. Subsequently, the sales forecasts have to align with the budgets and actual have to align with forecasts. This way there is goal congruence as well as making sure on a periodic basis that we are not off the budget by a great measure.
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While the supply chain department will put in their best effort to manage inventory, a key area in which the Sales & Marketing team can help is in the process of finding customers to liquidate slow and non-moving stock. This is very much possible as the sales managers have close contact with the customers of different segments and will be able to tap the right people who might be willing to take these material. While the supply chain team can take up the disposal of slow and non-moving raw material with the suppliers, support from Sales & marketing is essential for finished goods.
We all are aware that a sale is not complete until the money is collected. Collection of receivable is the prime responsibility of sales team and this is very key to the survival of the business. It is important for the sales manager to make it clear that the company agrees to the quality, price, delivery and credit terms with a promise that the first three aspects will be fulfilled by the company while the customer need to do his part in paying for the supplies on time and in full. A majority of the customers understand and pay promptly. However, if the company (supplier) shows slackness in following up, the customer develops a habit of paying only after some follow up and some hard chasing will be required if the delays are condoned. One might have observed that companies having cash flow problems often pay only the most persistent suppliers or those who act at the earliest by stopping supplies if the first promise after follow up is not met with. Habits once formed, both for prompt payment and / or delayed payment are very difficult to change and in some extreme cases possibly leading to losing the customer for good.
The sales managers are the best people to know if a customer is organised and how the payment process works in the customer company. Follow up and collection strategies may be different for customers like MNCs, private limited companies, partnership firms and sole proprietor organisations. MNCs and large private limited companies may have a monthly / fortnightly payment cycle to manage large supplier payments, and the smaller firms may not have such systems. Hence, depending on the customer organisation and payment process reminder phone calls, automated emails to the bill payment section on or before due dates, monthly statement of accounts, personal visits and casual courtesy visits can work to get the payments with a few days delays. Finance department staff has to work with a good understanding with the sales manager on the collection process and help provide a summary of the accounts receivable ageing statement to the sales manager at the end of each month and set a target for collection preferably with weekly targets. On a daily basis finance may monitor the bank accounts to check for collections and update the collections in the accounting system for generating dynamic reports as also to keep the sales team
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informed about the collections on a real time basis. It is quite normal for sales managers to skip the topic on collections when they are in discussions with the customer for a big order and therefore may have to revisit on another day. This is very much understandable in case the customer is a regular pay master and the invoices became due for payment just around the days of discussion.
On the contrary if the customer is not having a history of prompt payment the sales manager can include prompt payments as a point while the customer negotiates for price and delivery. Many a times because of the personality issues between the finance & sales teams focus on collections are not enough resulting in customers delaying payments and the cash flow situation of the company getting worse. Receivables being a key component of working capital will be increasing and working capital management gets tough. Keep all interdepartmental issues aside and face the market together. Most companies having cash flow issues have internal people oriented and system oriented issues. Finance, in their cash flow management process chase for collections, may not realise / understand the pains of the sales team who are struggling to grow the business due to competition in the market and some quality / delivery issues. Production, quality and supply chain teams should help the sales people to keep up the promises on fulfilling customer orders and when these obligations are handled professionally, the sales team will have no option but to follow up on collections on time. The customer will realise the great support by the company and reciprocate by paying on time without any hard negotiations for price and deliveries.
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13. Role of Production Department:
Normally many companies do not involve the production department head to be part of any discussions on inventory management or receivables management unless there are specific issues related to production. Companies can take a proactive approach and involve the production heads in inventory management by making sure that the production always follow the production plan without making switches in production schedules. Some times it is possible that the production department may alter the production schedule to achieve some economies of scale and for batch production there by improving the throughput in production. As a result of such changes in production schedules, some of the common raw materials may be consumed in excess of weekly plan and can cause raw material shortages for goods which are planned to be produced & dispatched that week. The result could be a shortage even after the safety stock is consumed. The company may be compelled to airlift raw material or request the customer to accept a rescheduled delivery date. If the production head is involved in the sales & operations review meeting to discuss production rescheduling for reasons of maintaining batch consistency in a large order spread over a couple of months or because of some anticipated machine down times, then the supply chain department can help provide their inputs to manage inventory better during those periods. The production department may also give their inputs in the ways the slow and non-moving raw materials can be disposed off or consumed. There are areas where the production team can help the customer service department in committing delivery dates for bulk and urgent orders from key customers. Involving production department can help in evaluating vendors and also help provide feedback to the suppliers to improve input material quality. Similarly quality department can help in recommending process adjustments to reduce rejections and also help fix quality issues based on customer feedback.
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14. Management Approach: In the preceding paragraphs we have seen how the different departments in a company can help manage working capital better in a more optimal manner and improve the profitability of the company. However, in reality the reactions of the functional managers are more a reflection of the top management style and culture which sets the tone of managing business. Companies which are in the initial phase of growth have a tendency to prioritise marketing initiatives more openly and instruct the operations team to make sure that sales team is supported at any cost. This is many a times wrongly misinterpreted and sales team tend to slack on maintaining sales forecast accuracy or provide budget / forecast numbers which are more not backed by proper ground work on the field. It is true that it is highly impossible for anyone to accurately forecast sales, but the sales team can base the forecast on customer and market statistics to make a reasonable sales estimate with their experience. Proper adjustments to the forecasts can be done as and when more confirmed information is available.
The direction from top management to support at any cost should not encourage over committing to customers and all efforts are to be made to work as a team along with operations to make sure that customers are supported well. Constant efforts are to be made to set and improve systems to closely interact with operations on forecasting, delivery commitments, establishing pricing policies and ensuring credit management policies are followed appropriately. Internal communication issues and lack of effort to understand the other functions are the major causes for poor working capital management. Similarly top managements backing to sales team (being the bread winner of the company) also could encourage lacklustre approach to implementing credit policies. Sales teams tend to take higher risks to grow sales and ignore normal validation processes. The top management has to communicate that the sales team is accountable for achieving sales numbers, providing reasonably accurate budget / forecasts, ensuring adherence to credit management policies / procedures and last but not the least work in close association with operations. Of course as a general rule, direction can be given to the total team to work on a business growth approach.
Managements in their periodic review meetings or in setting KPIs for operations set tougher and sometimes impractical targets without making proper changes in processes to backup the targets to be achieved. There will always be areas for improvement and every functional head will be striving to learn from the mistakes or errors in judgment to improve their processes. However, management has a role to play here by encouraging them to Page 44

experiment in and yet make them accountable for what they do. Good performance needs to be encouraged as much as bad performance or errors are being reprimanded. Management needs to be objective in their evaluation and not drive panic in the minds of the managers which can make the employees take a safer route in everything like keeping higher safety stock, keeping buffers in ordering process and over reacting to ordinary information. It is almost a set rule in many professionally managed companies that no operations person is allowed to second guess the sales forecast and those who do so will be accountable for any consequences. However, the demand planner and supply chain managers are allowed to ask for clarifications from sales team on spikes in demands based on which procurement will be planned. If the actual sales do not go per forecast inventory is unnecessarily built up and could result in blocking working capital funds for a longer period than normal. As a result of management strongly supporting a single function, other functional heads could withdraw from active participation in demand planning. Management may therefore take a neutral and professional approach to ensure all functions work as a team.
Similarly, senior managements tend to allow extra leniency to sales team in credit management which could lead to credit policies & procedures being only a theoretical exercise and finance could play a mute role in receivables management. It will be better that the Heads of Sales and Finance departments be allowed to balance the situation but with a customer and business oriented approach. If any of the functional heads see that the management is generally prejudiced, then functional goals will be difficult to achieve. Also the motivation levels and managerial skills of the respective functions could be very low. Hence, management may take the right approach to select the right professionals for the respective functions and leave the day to day management to the respective heads. Any unresolved conflict may be selectively handled at senior level and HR may be requested to plan for appropriate training to the concerned staff. Personality issues should be kept aside and chain mails need to be discouraged. Face to face meetings to explain view points and resolve issues amongst themselves need to be encouraged & welcome. There is something which managements can think of doing. Employees tend to hoard information and are critical of other functions over a period of time continuously handling the same job. Please identify talent and rotate jobs first within the function and if possible across functions. Let us look at one possibility of deploying a Accounts Payable accounts staff who has been in the company for three years either in Accounts Receivable role or in stores to get a perspective of other functions. Similarly, a production manager may be transferred to quality where the employee can understand the need to ensure quality or vice versa. Employee has to have the requisite qualification and have the enthusiasm to take new roles.
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15. Key Performance Indicators (KPIs):
15 (a) : KPI - Inventory
Working capital in dollar value indicates the amount of money invested or blocked in inventory, receivables net of vendor payables. However, in comparison with another company in the same industry such dollar value comparisons may not give any meaning unless the measurements are in parameters such as inventory as days of consumption, receivables as days of sales and payables as days of purchases. The companies may be of two different sizes and using two different technologies. Hence dollar value comparisons will not distinguish which of the two companies is more efficient than the other. Key performance indicators are therefore indicated as ratios or with relative factors to make the comparisons more realistic.
Let us identify the measurements for inventory. Inventory is first measured as number of days of consumption in the future. Inventory is built up with the objective of being prepared to meet the demand in the coming months. Inventory includes the following four classes raw material, semi-finished goods, finished goods and goods for resale. Each company has policies for stocking for different classes of raw materials - fast moving, medium and slow moving in terms of consumption. Fast or frequently consumed items are stocked for say 1530 days, medium frequent consumption items are stocked for 30-45 days and slow moving items are stocked for 45-60 days. This stocking pattern also has relevance that frequently consumed items are consumed in bulk and bought in bulk (like container loads) and the stock days are determined based on the normal and abnormal procurement lead times for replenishing stock. For medium and slow moving items, it will be economical to buy and store in lot sizes determined by consumption pattern and order processing costs. Apart from Inventory expressed in days of consumption, inventory is also expressed in the form of inventory to turnover ratio. The formula used here will be cost of goods sold / average inventory. The more the times inventory is turned over, better for the company. Some companies aim at 12 turns and more.
As regards semi-finished goods, companies maintain very little stock and normally only those semi-finished goods that can be converted to multiple finished goods as per market requirement are kept in stock. Another possible reason being, for example in chemicals, finished goods may have lesser shelf life and so it will be better to keep the stock at semifinished level. Yet another reason being that the finished goods are completely customised Page 46

to customer requirements and so semi-finished goods will help the companys ability to service such customised orders at shorter cycle times. Finished goods stocks are maintained by companies which have standardised products that are churned out in batches. Companies which manufacture customised products according to customer specifications normally have on the shop floor finished goods that are just waiting to be dispatched to specific customers. Finished and semi-finished goods are also measured in the same manner as raw materials.
Inventory Turnover Ratio
Cost of Goods Sold during the period ----------------------------------------------Average Inventory Beginning inventory + Ending inventory -------------------------------------------------2 = 365 days -------------------------------------------------Inventory Turnover Ratio
Average Inventory
Average days to sell the inventory
Companies determine their inventory turnover goals based on the gross margins they are able to generate. If the margins are in the range of 20% a ratio of 5 to 6 will be aimed at. However, for lesser than 15% margins, the companies do not block their funds as the cost of funds blocked may not be met with such low margins. Even in companies which maintain a turnover of 6 not all products will be turn six times. Fast moving items could be even 12 while some slow moving products may be just 3 or 4. Hence the Supply Chain Managers role in companies become very important and the management should give enough freedom for them to choose the right inventory strategy. Of course such authority will be go with the responsibility and accountability to make sure that customer orders are serviced as per companys objectives to grow market.
Finance and Supply Chain departments need to have a good understanding of the products, production processes, procurement processes, cost of working capital finance, availability of liquidity in the system and the margins the company earns on different products. Hence the golden triangle of Sales - Supply Chain - Finance need to work in cohesion to make sure that the inventory turnover is optimal. As changes are permanent and they happen all the time in the market, frequent reviews of inventory policies are required to allow flexibility for the company in achieving its objectives.
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There is a tendency amongst the purchasing team to stock up raw materials as there are news in the market or indirect info from suppliers that prices are likely to go up. Please buy only what is required for your production. There is no assurance that the prices will necessarily go up. Evaluate the benefit vs the interest cost and the cash flow situation in the company. Unless cognizable savings are foreseen please do not venture stocking up and blocking up funds. The supply chain manager may bounce off the idea with finance to weigh the cost vs benefit before yielding to such market news. Many companies trading in crude oil establish a proper system to evaluate market trends on oil prices and encash on any price advantages in pre-booking orders. There is an equal chance for losing out if either the prices do not move up as expected or on the contrary go down. Buy only what you need and do not get driven by sentiments. Kindly make sure that with appropriate inventory holding that customer orders are serviced in full. KPIs should help balance out between excess inventory vs inability to service customer orders on time.
In order to make improvements, general inventory reports with overall numbers will be of limited help. It will be very useful to generate a report showing the age analysis of inventory by line item calculating the age from the manufacturing date or procurement date if the suppliers manufacturing date has not been captured in the ERP system. If the inventory on hand by days of future consumption is calculated for each item, imbalances within each category of inventory will be noticed. It is very much possible that the SCM manager faces stock outs for some raw materials while the overall inventory is quite high. This may be because of imbalance in inventory and analysis at item level is required. Actions to liquidate excess inventory of slow and non-moving inventory is to be focused on.
Sample of a age analysis report is given below: Item Code MR40583 MP50896 MP50680 MR40980 Description Ethyl Acetate Ethyl Alcohol Casein MEK Location LW90 LW80 LW80 BK90 Batch Ref
AD12458 EA34988 LC45190 MA71486
0-30 1,900
31-60
61-180
>180
890 200 1,600
The age analysis of inventory will help the SCM Manager to focus on the old stocks to see how the same can used in production and be converted to finished good to make the product saleable. At times because of wrong picking of material, an old batch of a fast moving item Page 48

may have been left behind with potential of losing its shelf life. Regular review of the age analysis will help the company manage the inventory to be current & usable. This will also help identify the non-moving stock for disposal on time before the whole lot is declared as scrap. As we all know, chemical companies need to pay for disposing the chemicals apart from writing off the full value of the material.
Stock ageing analysis - Stock Summary as on 10th February 2011 Material Type Age <= 3 months Finished Goods Semi- Finished Goods Raw Material Grand Total 89,671 135,846 379,449 604,966 4-6 months 7,090 12,661 287,858 307,609 Qty in Kgs >6 months 10,445 30,783 217,758 258,985 Grand Total 107,206 179,290 885,064 1,171,560
It is important for the supply chain manager to regularly review the age analysis of stock by item as it can give plenty of information for correcting the processes. One of the reasons for having older stock in fast moving items could be as a result of materials not being strictly issued on FIFO basis. If materials issued to production are from recent batches ignoring the older materials, there is a possibility of older materials losing their shelf life and become unusable. The age analysis report can also throw light on materials being bought afresh when older materials are still available in stock. Another reason for aged stock I have come across is that the supply chain team is negotiating with the suppliers in connection with rejected material. This reflected some serious process weaknesses. First, how was the material taken into stock without the incoming material being approved by quality? Secondly, why the material was not returned to the supplier immediately upon being rejected by quality. Finally why should there be a negotiation with the suppliers on how the rejected material be handled. The process should have been detailed in the contract before the raw material purchase order is released. It is very much possible that because of delayed actions, the supplier has been paid for the defective material and that action to recover monies for such bad material along with other costs need to be identified & recovered. This reflects a poor vendor management process and should be attended to on priority. Page 49
Auditors normally insist on the company having norms to provide for obsolescence of materials primarily based on the age of inventory. Companies establish processes to provide for 25% of material that are 90-120 days old, 50% for items which are 121-180 days old and 100% for all items which are more than 180 days old. This process differ from industry to industry but for better reporting provisioning norms need to be clarified by the management in their annual report. This write off will have a direct impact on the EBITDA of the company and therefore inventory age analysis carries a lot of importance & attention.
15 (b) KPI - Receivables The second important component of working capital is Receivables. Companies in their zest for improving their market share tend to take risks by penetrating into new markets and get new customers on board. A proper evaluation of customers profile and determining the credit limit for such customers based on verifiable financial information / reports is to be done. The company commits to supply the best product, at best prices, delivery terms and even credit terms. Hence expecting the customers to pay on time is something the sales person need not feel shy to ask. All of us know that a sale is not complete unless the customer pays for the goods. While leaving the allowance of credit period to be determined by the sales manager either on account of market trends or as a tool to win an order, efforts are needed while following up for collections.
ERP packages of today can help generate receivables statements dynamically. The due dates are calculated from the invoice date according the credit days offered. The overdue statement helps the sales managers to focus on customers who have not paid. The company needs to have a proactive approach in managing receivables. At the end of each month prepare an ageing receivables report by region / sales manager so that the sales manager can plan his visits to provide timely reminders to customers to pay. There are companies which have a proper system to pay the suppliers on time and a mere statement of account will be sufficient.
Measuring the receivables in Days of Sales outstanding is the normal practice. Different customers may have different credit periods and sales can be in different currencies. If the outstanding is in multiple currencies please use company code currency (aka local currency) values to calculated DSOs. When calculating the DSO (Days of Sales Outstanding), total outstanding (including all due and not due invoices) is taken. This amount is divided by the average sales per month in $ to arrive at the DSO. Page 50
Days of Sales outstanding (DSO) =
Total outstanding in $ --------------------------Average sales per month in $
If you have a basket of credit terms for different customers in different regions compare DSO for each such region to compare with the credit terms allowed. Normally customers pay with a small delay of a few days resulting in +10% of days to settle. If the DSO is more than +10% of the average credit period for that market, then the company need to review the credit management process in general.
Here again, for better control, the ageing report needs to be prepared by region and by customer. You will normally find some trends in customer payments. Some customers have payment processing only twice a month and so may be regular that way, while others may take the route of processing payment only at the end of each month but will consider only invoices due till 15th of 20th of the month. Others may be habitual in paying only after we vigorously follow up. In a way such prompt or delayed payment habits are caused as a result of our credit management process. Finance and Sales Managers may help each other identify prompt payers and handle them just by sending them statement of accounts at the end of each month while for the defaulters credit blocks may have to be activated to convey our policy to the customer. Please compile the payment history for the past 12 months and send letters to the regular defaulters. Actions that may be taken are reduced credit terms or moving to secure terms like Letter of Credit. Whichever way, receivables need can be controlled only through collective cooperation of Sales & Finance functions who need to be flexible to support business growth.
Sample AR ageing report - LATIN AMERICA REGION (US$)

Customer Star Trade Galaxy Ltd Global Biz Sun Solvent Zodiac Ltd Total 36,200 129,850 9,450 28,900 32,800 13,600 15,950 15,300 12,350 4,500 Not Due 15,000 87,250 Current Month 0-30 2,850 42,600 9,450 5,650 31-60 8,200 61-90 4,500 91-180 >180
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All management reports are meant to convey key information to the readers and normally numbers indicate certain patterns. Data becomes information and information becomes knowledge upon proper understanding of the report. From the above mentioned sample report one can observe that though customer ABC has overdue in the range of 0-90 days, the company kept supplying goods and this reflects lack of credit control. Similarly customer XYZ, a new customer has been added with a sizable exposure of $ 129,850 in just two months. Upon investigation it appears that there is no process of credit evaluation when a new customer is added which allowed a new customer to buy such large volumes. The third customer PQR has stopped paying as well as stopped business and the exact reasons for discontinuance are not known. This reflects a poor sales and collection strategy / credit control. The Finance Manager claims that the DSO is 62 days against a normal credit period of 60 days. While apparently things may look fine, the age analysis report by customer gives a different picture.
It is a general practice the total outstanding is divided by average sales to calculate DSO. The DSO will look healthy when the sales show an increasing trend but in a seasonal business it is better to calculate working backwards by month. For example, if the total outstanding is US$ 1100k and the immediate month sales was US$ 350k and the previous month was US$ 450k, and the previous to previous month was say only US$ 600k, then the DSO should be 30 days for immediate month (covering US$ 350k out of 1200k), another 30 days for previous month (covering US$ 450k out of US$ 1200k) and (300/600) x 30 = 15 days totalling to 75 days. By the simple average method, DSO would have been [(1100k) / ((350+450+600)/3 )] x 30 = 71 days.
The sales manager may also be given a collection target to collect 90% of the opening overdue debt of each month and a minimum of 75% of the amounts falling due during the current month. Ideally 100% of the opening overdue debt has to be collected but a practical 90% is set as the first portion of the target. The second portion of the target will be 75% of the amounts falling overdue during the current month giving allowance that the amounts falling due in the last week could possibly spill over to the next month. A minimum YTD target of 80% is to be achieved. I have worked for a highly professional and system oriented company which successfully implemented this system and linked the YTD performance to the eligibility criteria for sales incentives to the sales & credit managers. In comparison to the inventory management where actions to optimise are within the control of the company executives, receivables management involves external parties (customers) to cooperate in keep the receivables under check. However, in my several years of Page 52

experience I have seen that customers normally reflect the same professionalism with which the company handle them. Hence Finance and Sales managers have to work together to have a proper credit management procedure and communicate to customers the essence of the sale transaction. Handle customers with respect and pick early symptoms of delay tactics to make sure that the message on payments on time is communicated. I am sure each of us have listened to all possible excuses for not paying on due date. As mentioned in the case of inventory, the auditors will review the age analysis of receivables and insist on provision for bad and doubtful debts being provided in the books of accounts. At the end of each year, please prepare a report collating the due dates and actual collection dates for all customers by invoice. This will help you to identify who are good paymasters and who are not. The data can be used to modify your collection strategy and credit limit for each customer as also pressing for more secured terms where necessary. This may be taken as a pre-budget exercise to make sure that the analysis gets due management attention for efficient working capital management.
15 ( c ) - KPI Payables:
The final component in working capital management being vendor payables, let us look at how prompt payments to vendors help the organisation. It is true that most suppliers agree for an interest free credit period to their customers while companies having monopoly control or certain industries by virtue of custom do not offer credit. Even in industries where credit is normally allowed, credit is not offered to customers who are not well known or are strangers or where the customer is located in a different country. Some suppliers insist on advance payments, some are prepared to give credit if letter of credit is opened in their favour with the main objective of securing themselves while dealing with unknown markets / customers. However, after a few transactions, they will be willing to ease the terms. Measure the vendor payables also as Days of Purchases outstanding. I have seen that in some companies, the key raw material suppliers will have a different set of terms like LC 60 days and in some cases with 100% advance. However, other not so critical suppliers like for packing material, consumables, local transporters, freight forwarders may be under open credit ranging from 30 to 60 days. As these companies go through any cash flow gaps, payments for the vendors who give open credit will be delayed sometimes piling up to a couple of months overdue. These unsung heroes who are patient enough to support the company need to be paid on time as per the agreed credit terms. Hence please calculate DSO for secured terms suppliers and open credit suppliers separately to see where the company needs to be managed. I would recommend to approach LC secured term suppliers to increase credit Page 53

days instead of delaying payments to open vendors. In dollar terms also purchases from the key raw material suppliers will be much higher compared to the other suppliers who are on open credit. The vendors on open credit may not be too willing to reduce their prices where possible because payments are invariably delayed.
Sample AP ageing report - Zenith Solvents International P Ltd - Amounts in US$

Customer Fuji Chemicals LK Solvents NFY Logistics Sun Solvent Solarchem Cr days LC60 Op90 Op60 Op90 LC30 Total 180,400 78,900 19,200 48,900 62,800 Not Due 115,800 37,250 14,900 23,400 62,800 Current Month 64,600 35,600 4,300 15,300 10,200 6,050 0-30 31-60 61-90 >90
You might observe from the above AP ageing report that though the company did not have any long overdue payments to vendors, it still has a tendency to delay open credit payments while LC vendors get paid on due dates through bank. The company while measuring the days of purchase value outstanding need to calculate the days separately for LC vendors and open vendors to reflect the correct picture on managing cash flow / working capital.
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16. Benchmarking For every company and for every performance metric a proper benchmark (obviously the known best in the industry / region) should be identified for achievement. For example, a company may be currently having an inventory turnover of only 2 (6 months stock) and may have its own valid reasons to remain so. People who have been managing at that level for years need to have the conviction that it is possible to improve it in the first place. The company should look for information from other players in the industry to see if they have a better inventory turnover. Sometimes it may be difficult to directly achieve a level of 12 turns from a current 2. In that situation, a team of executives with a positive mind should try to find out the best way to achieve this through various process improvements. First and foremost is the belief that it is possible to achieve the target turns, secondly accept the current weaknesses in the systems - could be even lack of knowledge or skills to get that done. A proper problem solving approach need to be followed as detailed below
Step 1 - Identify the problem (2 inventory turn is only a result and not the problem per se). Problem can be anything from poor sales forecast, poor MRP planning, or even poor vendor management system. Apply cause and effect filters to identify real causes
Step 2 - Analyse the problem - Analysing with factual data like sales forecast accuracy over the past 12 months, flaws in the MRP planning & procurement, vendorwise info on timely deliveries, rejections data etc. Use fish bone chart to get a visual effect of all the causes & sub-causes leading to the current level of inventory.
Step 3 - Generate potential solutions for each of the main and sub-causes with clear metric for measuring progress. Involve all related functions to develop a standard operating procedure (SOP) and communicate to all.
Step 4 - Select and Implement the solutions with SOP and collect data on the performance of each aspect on a periodic basis - like forecast accuracy by month, ordering failures etc.
Step 5 - Monitor the solutions based on factual data. Apply PDCA ( Plan, Do, Check and Act) if the results are not to the desired level and repeat exercise until they are achieved.
In the initial stages it is important to set small achievable targets so that employees get involved and committed to their role. Once the desired level of performance is achieved set a
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process to improve the procedure to move from say 2 to 4 turns , 4 to 8, 8 to 10 and then 10 to 12. Once employees taste success improvements will happen in all areas on its own.
As many golfer friends would agree, each player has to compete only with himself and try to focus on the process to improve his score. Similarly, in managing working capital each company will have to compete with its own & even the best managed companies will try to improve processes for achieving a more optimum working capital to run the business profitably. Bench marks with other companies are useful where the concerned managers are either not convinced that such optimisation is possible or when they do not have experience working with well run companies.
There is nothing wrong in accepting the fact that the working capital situation needs to be improved and seek appropriate consultants help in getting the people trained to make the changes. I had the opportunity of working with a Supply Chain Manager who was having apprehensions that if he reduced inventory he will be pulled up by the management for not being able to service some of the customer orders. Instead of analysing the reasons for failure and correcting the processes, he felt victimised and kept huge stocks of wanted and unwanted materials so that all forecasted and unforeseen orders are serviced. In my opinion he was shouldering the responsibility of all forecast errors and was not taking up the subject with Sales Managers. Over a period of time I helped him to overcome this apprehension and he was able to reduce the stock level by modifying the ordering pattern and through discussions with suppliers on delivery times. People need training and should be given opportunity to experiment new strategies. Managements should encourage people and not reprimand staff for one time failures. A smart employee will not repeat the mistake and will make sure that the processes are modified to avert a repeat of that mistake.
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17. Interest Cost impact: Every business and more particularly new businesses need to invest substantial amount of money in working capital. Whether the money is borrowed or invested by the owners, there is a cost for the borrowed funds and an opportunity cost / expected return for the owners funds. Banks provide working capital support in the form of trade finance facilities. Bill discounting or TR financing rates vary from bank to bank and even from the same bank interest rates vary for each customer depending on the credit rating of the company. In developing countries cost of funds is generally high and unless the business is able to earn much more in margins from the sale, it will be a fruitless exercise to earn margins and pay the bankers because of poor management of working capital.
It is therefore important to not only borrow less, borrowing at the right affordable cost is more important. CFOs manage the responsibility of negotiating with the banks to get the lowest possible interest rate for working capital financing. The companys operations and marketing teams need to know the cost of such facility as also understand how they can contribute to reducing the interest cost burden.
In the case of receivables if the sales team can keep the credit period given to customers to the minimum then the bill discounting interest charge for the credit period will be correspondingly less. When a bill (sales invoice) is discounted with a bank for getting cash flow upfront the banker agrees to wait until the customer pays to them. Until that period interest is charged and deducted upfront while paying the invoice value to the company. In many cases, the banks will discount and give only a maximum of 75% of the invoice value. The next step from the company side is to ensure that the collections on such discounted bills are collected on time so that the banks do not charge overdue interest. Overdue interest is always a few % higher than the normal interest rate and the banks may choose not to discount invoices on customers who delay payments. Factoring agents also do discounting but their rigorous follow up with customers could jeopardise your companys relationship with the customer.
Banks do offer a lesser and competitive interest rate for discounting bills (sales invoices) supplied under a letter of credit as there is complete assurance on payment. Hence the sales manager can sell on letter of credit terms to customers in order to (a) be sure that monies will be collected on due dates and (b) pay least cost for discounting bills supplied under LC. While negotiating with customers the sales manager may offer the least credit days and preferably on LC terms. Most companies are first interested in the right product Page 57

specification and the right quality at the right price. While price and credit terms are negotiated to get some additional benefit, customers will not decide on vendors who give additional credit terms. They may see that as a weak approach to get the order. Hence be upfront with customers and offer standard credit period. This will help both the company and the customer. I have personally experienced where a MNC in specialty chemicals (new entrant in local market) refused to give any additional credit over normal 60 days to distributors who were expected to stock and sell. Initially the distributors grumbled but later they understood that the companys core focus is in providing technically superior product with international quality and good after sales service and not in financing the distributors by giving additional credit to grow business.
Let us now consider how inventory costs money. Apart from inventory carrying cost in the form of warehousing and insurance costs, many do not realise that we pay interest on the value of inventory held by the business. Companies which avail of trade finance facilities from banks in the form of letter of credit or Trust Receipt financing paying a sizable amount while the material is still in stock. Ideally when you buy the material, it should be converted into finished goods with the shortest production lead time and get converted into receivables as soon as it is sold. However, if the raw material or semi-finished or finished goods still remain in stock, after the credit free period we pay real interest to the banks. Companies which use their own funds to keep inventory have a notional (opportunity cost) cost of funds blocked. Had that money been in the bank in the form of deposit or helping reduce the cash credit / overdraft amount, the interest on the amount locked up in inventory is the bank interest paid / payable on the funds.
You all may be aware of companies having huge slow & non-moving inventory. Imagine if the material were sold the company would have cash that could earn interest. Supply chain managers need to focus on having absolutely minimal and if possible no slow or non-moving inventory. It may be worth considering scrapping such material and realise even 50% of cost. Some companies promote a special scheme to dispose all slow moving stock at cost and also pay sales incentive for converting them into cash. One dollar saved is one dollar earned. Please go for it and keep absolute minimum / optimum stock. We are not recommending Zero stock as is being handled in automobile industry. Please avoid having several layers of buffer stock which can take all unplanned demands. Excessive stocks normally cover inefficiencies in sales forecasting, procurement planning and even production planning. If the processes in sales forecasting, MRP planning and production planning are
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improved marginally the result can be a good saving in inventory carrying cost & help improve cash flow.
Lastly, it is important to manage creditors right at the stage of selecting your vendors. Many of the purchasing department heads would agree that a vendor is selected only for being a reliable qualitative supplier and not for being the cheapest supplier or the one giving maximum credit. However, given all key parameters being the same vendors giving too low a credit or ones who give the highest are generally eliminated for being unreasonable either way. A new business venture, however, cannot get the same level of price and credit terms offered like an established business and may be asked to pay in advance or cash on delivery. After a couple of transactions where the supplier and customer understand each other one needs to stabilise the cash flow by getting some credit and help grow business. Let us take for example a person is dealing in Sony Television sets and he has to initially put in his own money for the first 30 sets. If he does have a good proposition to grow the business, he can talk to the wholesale distributor to get some credit of say 30 days so that he can stock more varieties to offer to customers. If the distributor either asks for deposit or if the amount is borrowed from a bank we pay interest on the borrowed funds. Hence please talk to your suppliers but do not go to the extent of breaking your relationship and make the supplier run away from you. Keep up your promises to pay on the due date.
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18. Creating awareness and removing myths
Generally companies have working capital issues mainly because of lack of internal cooperation between sales - operations, operations - finance and finance - sales etc. The underlying reason for such discomfort or lack of cooperation is the lack of transparency / trust between the functional heads. Please trust each other and believe that working together can help manage external market realities better. Our competitors are outside the company and not within. It is the responsibility of the management to encourage a positive culture so that the people at the operating level are empowered to the extent that they are able to take decisions and take responsibility for their actions. Managers could make mistakes in judgement that can cost some money. Management should help them to understand how and why their judgements went wrong and how they could be avoided in future. Employees will respond to this positive approach and take ownership for their actions to make sure that costs are saved in areas which normally do not come to management attention. However, in spite of such encouragement, we do see conflicts between functional heads. Let us understand why and how they can be handled.
Every functional head wants to protect their area and keeps buffer so that business is smooth even if something does not go as per plan. Managers need to ensure that 80% of the business activities run in a smooth manner by ensuring that the process is clearly communicated to the employees concerned / involved and the balance 20% of the activities are managed as an exception. People at the operating level need to be empowered to decide according to what the procedures allow and any deviation may be referred to the manager. However, as a result of the buffer in the system, most of the problems get solved without much correction to the process. For example, safety stock, reorder levels and purchasing lead times are padded with about 20% to 40% so that there is no stock out situation at any point of time. It is often forgotten that safety stocks are meant only for consumption and the system need not have additional buffer stock to protect safety stock being used. At each level people want to be cautious and therefore the safety stock itself is calculated very high. Formula for calculating safety stock, reorder level etc have been detailed in the respective paragraphs in this book. Purchasing and production lead times are also calculated with a few days buffer in each step. All these buffers increase the stock level which costs cash flow and interest cost.
Similarly, while preparing sales forecast every conceivable potential order is taken into account irrespective of whichever stage the discussion is in. This inflates the forecast
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numbers which is the basis for the operations team to work out their demand plan which is finally converted into material procurement plan. Operations team members opine that the forecast numbers are historically only 50% accurate and therefore may tend to discount their purchase plan accordingly. If in any of the months the sales manager does get orders close to the forecast, there are bound to have failures in deliveries. Hence it is always advisable that sales forecasts are prepared carefully to aim at a minimum of 75% to 80% accuracy and no operations team member is allowed to second guess the forecast. Supply chain manager may ensure that the ordering process including raw material classification, setting up of safety stock & reorder level, calculation of procurement lead time are carefully calculated without buffer and only at the final level allow a 5% to max 10% allowance for unforeseen consumption. Buffer at each level will add up so much and control will be lost. Process inefficiencies will be swept under the carpet and the buffer stocks will block all improvement needs. We all will agree that these inefficiencies will ultimately cost money to the company. Finance manager can take the lead in talking to both the sales manager and the supply chain manager in making sure that the objective of a monthly sales and operations review system is properly understood. Weekly meetings between sales, operations and finance need to be held to make sure that all the members have a common business perspective and support each other.
Another common area where Supply Chain Managers take a over conservative decision is when handling unofficial and unconfirmed information about price increases. This happens in commodities and also petroleum based products causing the buyer to rush and place orders for huge lots that could last some months. This knee jerk reaction to unconfirmed information is often done with a view to save a few thousand dollars on potential price difference. However, what is not considered in making the decision is the interest and inventory carrying cost involved in holding material. The company could go through cash flow hiccups and this should be resisted the first time and every time. At the same time where the benefits are likely to be substantial and can be matched with a back to back sale for benefit, the decision will be worth taking as long as we have information to distinguish between real information and rumour to stimulate demand.
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19. Tools and Key Strategies:
Working capital management is both a science and an art. Science because it is driven by facts and figures to determine how much of inventory is required to run the business. However, it is an art because the exercise begins with making a sales forecast which is a best estimate given the market conditions prepared by the sales manager. Different people can read the market differently. I would like to share a small example of how the view changes from one sales manager to another.
A shoe and chappal manufacturer deputed a sales person to visit and survey a remote place to explore market potential for chappals and shoes. The sales manager reached the place and went around the habitat in amazement. He then sent out a message back to headquarters quoting No one knows what a chappal is and all have been walking bare foot for several years. I am returning back to office today itself. The Director of Sales decided to depute another sales person to the same place without telling about the previous sales manager who is on his way back. The second sales manager landed there, went around the place and sent out a message quoting No one knows what a chappal is and all have been walking bare foot for several years. Please send 10,000 pairs immediately. He distributed the chappals free to people and requested them to provide feedback after using it. There is no need to guess further, the company found a totally virgin market and sales grew year on year.
In another example that can be quoted is the way the supply chain manager negotiates with the freight forwarders rates for the next budget year. The view and position he takes on the volatility in freight rates due to oil price fluctuations based on economic indices and global business news is an art. However, the rates negotiated can be agreed to be applicable under specific price bands. Should the prices move either way beyond the agreed band, the parties may agree to a formula by which the rates may be adjusted.
A third example is where the Finance Manager has a need to hedge forex risks. The Finance manager identifies the currencies that need to be hedged. As a result of a natural hedge for the major currency the company has covered more than 80% of the FX risks. However, the balance 20% exchange risks need to be identified by the Finance Manager. Scientifically there are products like forward selling and derivatives that can be chosen to handle this. Experience helps the Finance Manager to strategically buy a combination of these products
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in order to minimise the costs and maximise the cover with room for earning profits from upside of the FX movement.
Let us now look at the scientific methods of sales forecasting. Statisticians have built models for different industries - seasonal, non-seasonal, food, white goods etc. I would like to share names of some of the tools like Minitab, Crystalball, Alight, Manugistics etc. I am yet to use these myself, users are advised to find out the right tool suitable for their industry. These tools use statistical analysis of the past / historical data for trends and use the same for making base projections for the future with the assumption that the market has not changed much. However, the sales managers are advised to use this base forecast to build all the sensitive information by product to adjust the base info to arrive at their own forecast. Software tools are primarily only as good as the input data and the parameters set for the extrapolation. However, over a period of time, the chosen software model can be improved / customised to give a higher forecast accuracy compared to a mere estimation.
As regards using tools for inventory we all know that inventory is meant to service future customer orders swiftly and also to service customer orders placed covering multiple products on time and in full. Setting servicing standards like order fulfilment of 99% OTIF (On Time In Full) as per customers delivery expectations and achieving them consistently helps companies to become the most trusted and reliable partner to all business organisations. However, the quantum of inventory has to be more finite and more importantly affordable for the company. The starting point for estimating the quantum of inventory to be held in business is to determine order servicing standards and is mostly determined by the market / industry norm. In the case of cosmetics or consumer goods though customers may have some amount of brand loyalty, still the company has to make sure that super markets are stuffed with the products on their shelves and never give room for the customers to go for alternate product brands.
In the case of automobile industry though customers may like to walk in and drive out a car of their choice, some amount of customisation of interiors, colour, accessories etc can be provided within a few days. Customers are willing to wait upto a few weeks for some brands of cars but not too long. Competitors will be waiting for opportunities where the company is unable to deliver at the customers requested date to move in and grab the customer. Here stocks of more fast moving models and colours are kept by companies and variants are manufactured with the shortest possible lead time. In capital equipment industries customers
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are more open to wait for up to a few months depending on the extent of customisation. In these markets sub-assemblies are kept in stock to build the finished good asap.
Let us assume that company A is in an industry where the customers expect the goods to be put on a truck or ship within a maximum of 3-4 days from order placement. Assuming that the production lead time is say 3 days and purchasing lead time for raw materials (including shipment in) is about 3 weeks. Ideally it will be good for the company to keep one months stock of raw materials and keep replenishing stocks on a weekly basis. Safety stock may be worked out to accommodate any abnormal variations in demand and a reorder level may be set as mentioned in the paragraphs mentioned earlier. It is important that the sales forecast based on which the inventory holding level is calculated should be reasonably close to the actual as otherwise the company may end up having more inventory than needed. Some of the excess material on hand could go obsolete and all the excess inventory holding will result in non-value adding costs which can be very well avoided. Once the overall inventory level is strategised, production plan can be scheduled to suit the market demand and this way company can service customers swiftly and achieve OTIF.
Next let us look at the overall working capital requirement calculation model. The following template can give a fair idea of how the tool can support in estimating the value of working capital.
+ Inventory (as per the stock and delivery policy of the company) + Receivables (as can be worked out from the credit policy of the company). (-) Payables (based on the credit days allowed by suppliers and service providers)
Let us now work out for one quarter and the same table can be extended to cover a full year.
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Example Profit and Loss Account Amounts in USD 000 Particulars Revenue COGS (70%) Gross Profit Fixed costs EBITDA Interest Depn & Amort Net Profit Jan 2011 90,000 63,000 27,000 12,000 15,000 900 2,000 12,100 Feb 2011 110,000 77,000 33,000 12,000 21,000 985 2,000 18,015 March 100,000 70,000 30,000 12,000 18,000 1,015 2,000 14,985 Q 1 Total 300,000 210,000 90,000 36,000 54,000 2,900 6,000 45,100
Working for Inventory Particulars Opening stock Purchases Consumption Closing stock Jan 2011 90,000 60,000 63,000 87,000 Feb 2011 87,000 70,000 77,000 80,000
Amounts in USD 000 March 2011 80,000 90,000 70,000 100,000 Q1 Total 90,000 220,000 210,000 100,000
Working for Receivables Particulars Op Debtors Sales Collections Cl Debtors Jan 2011 180,000 90,000 80,000 190,000 Feb 2011 190,000 110,000 100,000 200,000
Amounts in USD 000 March 2011 200,000 100,000 130,000 170,000 Q1 Total 180,000 300,000 310,000 170,000
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Payables including Purchases and Fixed costs Particulars Op Creditors Purchases Payments Cl Creditors Jan 2011 90,000 72,000 82,000 80,000 Feb 2011 80,000 82,000 85,000 77,000 Amounts in USD 000 March 2011 77,000 102,000 90,000 89,000 Q1 Total 90,000 256,000 257,000 89,000
Net Working Capital Particulars Inventory Receivables Payables Net Working Capital Opening 90,000 180,000 (90,000) 180,000 Jan 2011 87,000 190,000 (80,000) 197,000
Amounts in USD 000 Feb 2011 80,000 200,000 (77,000) 203,000 March 2011 100,000 170,000 (89,000) 181,000
Interest cost @ 0.5% per month (6% p.a) works out to USD 900k for Jan 2011, 985k for Feb 2011 and 1,015k for March 2011.
The above template can be extended to workout a trade financing limit requirement and also a cash plan for the company. The maximum amount of bill discounting and LC requirement will help map your cash flows to help your bankers to understand your facility limits needs. They will also be looking at your debt service cover ratio as per formula given below : EBIT ---------------------------------------------------------------------------------------------------------------------{Principal repayments due / (1-tax rate) } + {Interest payments due during the period}
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20. Continuous Improvement - using PDCA approach : Now that we have a reasonable overall view of working capital, its components, its determinants and the ways to manage them at optimal levels we now can look at ways to make improvements to make the process efficient. We know that the performance indicators like inventory in days of future consumption or stock turns, receivables in days of sales and creditors in days of purchase. Every company that is managed professionally would like to see how best things can be improved. For each of these parameters a measurable target may be set and a core team comprising of staff from the relevant departments may be involved to study what needs to be done to achieve the target. Using of PDCA IPlan, Do, Check and Act).
Let us now take an example of how to improve DSO in receivables and how PDCA can be applied. To start with let us assume that the current DSO level is 85 days as against an average contracted credit period extended of 68 days. The average 68 days comprise of 30% of customers having 90 days credit, 60% of customers having 60 days credit and balance 10% of customer having 45 days. As against each of these categories we need to first map how the actual performance has been till date in the year. Customers in one of the regions who are already availing 90 days credit per contract settled their outstanding only after 110 days (as against 90 days), similarly customers who were given 60 days actually settled their bills after 75 days and the third category who were offered only 45 days settled after 70 days. Following the problem solving process, we have now identified the problem which caused the DSO to be at 85 days as against 68 days. Though the management may feel that 85 days is not bad, the company faced cash flow issues and so there was a need to review the receivables control measures.
The Sales Manager and CFO together decided to redraft the credit management policy and decided to set individual credit limits for each of the customers depending on their volume of business, credit days and even the payment methods like LC, open credit, payment history etc. Credit blocks in the ERP were to be triggered even if any of the invoices within the credit limit were overdue for payment. The sales manager and CFO jointly decided to review each such case to decide on releasing orders that were credit blocked. The sales manager also decided to talk to the first group of customers who are already availing 90 days as per contract and delaying by 20 days additionally. With the credit block customers were informed as and when the invoices fell overdue. While some of the customers understood their internal process issues on payment, others were a bit reluctant. The sales manager then Page 67

decided to increase the credit for third group from 45 days to 60 days but added a condition that interest @ 12% p.a will be charged on any default after 60 days. This restrained some customers who were habitually not paying on time. The remaining group which were paying15 days later than 60 days were informed about the new approach of management on credit policy and explained how the company can help in their core areas like product innovation, quality and supply chain improvements. After the initial Planning (P), and Doing (D) through communication of credit policy for a couple of months, the sales manager Checked (C ) if the efforts were making any improvements. At this stage they did see significant improvements in many areas while some customers were continuing to follow their old methods of payment. After stabilising the new policy for a few months in a row, the sales manager decided to Act (A) again with a revised set of strategy for handling the customers who did not cooperate as much. Like this PDCA can be used along with the problem solving process to make sure that the goals of improving working capital efficiency is achieved.
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21. Conclusion: Working capital is the life blood of business. We cannot afford to have excess nor be short of required quantum for a healthy business. Organisations which have failed to make it big and ultimately perished have one thing in common - they have failed to manage their working capital. In some cases poor management of inventory, receivables and consequentially delayed payments to vendors have been the main cause for the downfall of the companies. Another reason which contributed to poor management of working capital is due to diversion of working capital funds for long term use like purchase of machinery, or paying term loan instalments etc.
As a result, paucity of funds trigger extra cautious approach by supply chain managers to stock up inventory and this causes cash flow hiccups. A third common reason is the apprehensive approach of sales mangers in asking for the overdue payments from customers fearing that customers may shift to new suppliers. This knee jerk reaction would slow down collection and it is a fact that more the time you leave money in the market, the greater is the risk of collecting the debt. That is why auditors insist on provisioning norms for debts which are older than acceptable standards.
The objective of this handbook is to highlight the various aspects of working capital components and the various issues around managing the same efficiently. These are completely based on my personal experiences and are my view points as a business manager.
A quick summary of the key measurements for the three elements of working capital are given in Annexure 1.
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Annexure 1 A short recap of the measurable parameters relating working capital is given below.
Ratio Stock Turnover (in days) Formulae Average Stock * 365/ Cost of Goods Sold Result =x days Interpretation On average, you turn over the value of your entire stock every x days. You may need to break this down into product groups for effective stock management. Obsolete stock, slow moving lines will extend overall stock turnover days. Faster production, fewer product lines, just in time ordering will reduce average days.
Receivables Ratio (in days)
Debtors * 365/ Sales
=x days
It take you on average x days to collect monies due to you. If your official credit terms are 45 day and it takes you 65 days... why ? One or more large or slow debts can drag out the average days. Effective debtor management will minimize DSO
Payables Ratio (in days)
Creditors * 365/ Cost of Sales (or Purchases)
=x days
On average, you pay your suppliers every x days. If you negotiate better credit terms this will increase. If you pay earlier, say, to get a discount this will decline. If you simply defer paying your suppliers (without agreement) this will also increase - but your reputation, the quality of service and any flexibility provided by your suppliers may suffer.
Current Ratio
Total Current Assets/ Total Current Liabilities
=x times
Current Assets are assets that you can readily turn in to cash or will do so within 12 months in the course of business. Current Liabilities are amount you are due to pay within the coming 12 months. For example, 1.5 times means that you should be able to lay your hands on $1.50 for every $1.00 you owe. Less than 1 times e.g. 0.75 means that you could have liquidity problems and be under pressure to generate sufficient cash to meet oncoming demands.
Quick Ratio
(Total Current Assets Inventory)/ Total Current Liabilities
=x times
Similar to the Current Ratio but takes account of the fact that it may take time to convert inventory into cash.
Working Capital Ratio
(Inventory + Receivables Payables)/ Sales
As % Sales
A high percentage means that working capital needs are high relative to your sales.
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OTHER PUBLICATIONS BY THE AUTHOR
Krishnamachari Srinivasan (Krish) wrote his first book for budding Finance Managers (FM) and Finance Controllers (FC). The book provides a good insight about the role FM and FC are expected to play in running an organisation. The author has shared his personal experiences and learning over nearly three decades that will help bring harmony amongst the functional managers. The book is available on scribd.com with the title A Controllers handbook.
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Working Capital Management - by Krishnamachari Srinivasan

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