WORKING CAPITAL CYCLE

The upper portion of the diagram above shows in a simplified form the chain of events

in a manufacturing firm. Each of the boxes in the upper part of the diagram can be seen

as a tank through which funds flow. These tanks, which are concerned with day-to-day

activities, have funds constantly flowing into and out of them.

The chain starts with the firm buying raw materials on credit.

In due course this stock will be used in production, work will be carried out on

the stock, and it will become part of the firm’s work-in-progress.

Work will continue on the WIP until it eventually emerges as the finished

product.

As production progresses, labor costs and overheads need have to be met.

Of course at some stage trade creditors will need to be paid.

When the finished goods are sold on credit, debtors are increased.

They will eventually pay, so that cash will be injected into the firm.

Each of the areas- Stock (raw materials, WIP, and finished goods), trade debtors, cash

(positive or negative) and trade creditors – can be viewed as tanks into and from which

funds flow.
Working capital is clearly not the only aspect of a business that affects the amount of

cash.

The business will have to make payments to government for taxation.

Fixed assets will be purchased and sold

Lessors of fixed assets will be paid their rent

Shareholders (existing or new) may provide new funds in the form of cash

Some shares may be redeemed for cash

Dividends may be paid

Long-term loan creditors (existing or new) may provide loan finance, loans

will need to be repaid from time-to-time, and

Interest obligations will have to be met by the business

Unlike, movements in the working capital items, most of these ‘non-working capital’

cash transactions are not every day events. Some of them are annual events (e.g. tax

payments, lease payments, dividends, interest and, possibly, fixed asset purchases and

sales). Others (e.g. new equity and loan finance and redemption of old equity and loan

finance) would typically be rarer events.

SOURCES OF WORKING CAPITAL

requirements in order to carry on its operations smoothly:

Banks:

These include the following banks –

State Bank of India

Canara Bank

HDFC Bank Ltd.

ICICI Bank Ltd.

Societe Generale

Standard Chartered Bank

State Bank of Patiala

State Bank of Saurashtra

Commercial Papers:

Commercial Papers have become an important tool for financing

working capital requirements of a company.

Commercial Paper is an unsecured promissory note issued by the

company to raise short-term funds. The buyers of the commercial

paper include banks, insurance companies, unit trusts, and companies

with surplus funds to invest for a short period with minimum risk.
NTPC issues Commercial Papers and had 4000 commercial papers in

the year 2006.

Inventories

Inventories constitute the most important part of the current assets of large majority of

companies. On an average the inventories are approximately 60% of the current assets

in public limited companies in India. Because of the large size of inventories

maintained by the firms, a considerable amount of funds is committed to them. It is

therefore, imperative to manage the inventories efficiently and effectively in order to

avoid unnecessary investment.

Nature of Inventories

Inventories are stock of the product of the company is manufacturing for sale and

components make up of the product. The various forms of the inventories in the

manufacturing companies are:

Raw Material: It is the basic input that is converted into the finished

product through the manufacturing process. Raw materials are those units

which have been purchased and stored for future production.

Work-in-progress: Inventories are semi-manufactured products. They

represent product that need more work they become finished products for

sale.
 Finished Goods: Inventories are those completely manufactured products

which are ready for sale. Stocks of raw materials and work-in-progress

facilitate production, while stock of finished goods is required for smooth

marketing operations. Thus, inventories serve as a link between the

production and consumption of goods.

Inventory Management Techniques

In managing inventories, the firm’s objective should be to be in consonance with the

shareholder wealth maximization principle. To achieve this, the firm should determine

the optimum level of inventory. Efficiently controlled inventories make the firm

flexible. Inefficient inventory control results in unbalanced inventory and inflexibility-

the firm may sometimes run out of stock and sometimes pile up unnecessary stocks.

Economic Order Quantity (EOQ): The major problem to be resolved is

how much the inventory should be added when inventory is replenished. If

the firm is buying raw materials, it has to decide lots in which it has to

purchase on replenishment. If the firm is planning a production run, the

issue is how much production to schedule. These problems are called order

quantity problems, and the task of the firm is to determine the optimum or

economic lot size. Determine an optimum level involves two types of

costs:-
 Ordering Costs: This term is used in case of raw material and

includes all the cost of acquiring raw material. They include the costs

incurred in the following activities:

 Requisition

 Purchase Ordering

 Transporting

 Receiving

 Inspecting

 Storing

Ordering cost increase with the number of orders placed; thus the more

frequently inventory is acquired, the higher the firm’s ordering costs. On

the other hand, if the firm maintains large inventory’s level, there will be

few orders placed and ordering costs will be relatively small. Thus,

ordering costs decrease with the increasing size of inventory.

 Carrying Costs: Costs are incurred for maintaining a given level of

inventory are called carrying costs. These include the following

activities:

 Warehousing Cost
  Handling

 Administrative cost

 Insurance

 Deterioration and obsolescence

Carrying costs are varying with inventory size. This behavior is contrary

to that of ordering costs which decline with increase in inventory size.

The economic size of inventory would thus depend on trade-off between

carrying costs and ordering cost.

Compositio 2008 200 200

n 7 6
Raw 6349 774 612

Material 9 7
Stores and 3713 298 262

Spares 7 2
Finished 1337 724 650

Goods 4 5 6
Work-in- 595 784 871

progress

The increasing component of raw materials in inventory is due to the fact that

the company has gone for bulk purchases and has increased consumption due to
a fall in prices and reduced margins for the year. Another reason might be the

increasing sales, which might have induced them to purchase more in

anticipation of a further increase in demand of the product. And the low

composition of work-in-progress is understandable as because of the nature of

the business firm is involved in.

To the question as to whether the increasing costs in inventory are justified by

the returns from it the answer could be found in the NTPC retail expansion.

NTPC caters to the need of the two separate segments:

a) Institutions for which they manufacture against orders and,

b) Retail segment of the market.

They are more into retail than earlier and at present more than 650 retail outlets

branded with NTPC sign ages and more are in the pipeline

The company in order to meet its raw materials requirements could have gone

for frequent purchases, which would have resulted in lesser cash flows for the

firm rather than the high expenditure involved when procuring in at bulk. The

reason why the firm has gone for these bulk purchases because of the lower

margins and the discounts it availed because of procuring in bulk quantities.

A negative growth in WIP could be because:

a) The time taken to convert raw materials to finished goods is very

minimal
 b) This is also due to capacity being not utilized at the optimum.

ABC System: ABC system of inventory keeping is followed in the

factories. Various items are categorized into three different levels in the

order of their importance. For e.g. items such as memory, high capacity

processors and royalty are placed in the ‘A’ category. Large number of

firms has to maintain several types of inventories. It is not desirable the

same degree of control all the items. The firm should pay maximum

attention to those items whose value is highest. The firm should therefore,

classify inventories to identify which items should receive the most effort in

controlling. The firm should be selective in approach to control investment

in various types of inventories. This analytical approach is called “ABC

Analysis”. The high-value items are classified as “A items” and would be

under tightest control. “C items” represent relatively least value and would

require simple control. “ B items” fall in between the two categories and

require reasonable attention of management.

JIT: The relevance of JIT in NTPC Info system can be questioned. This is because

they procure materials on the basis of projections made at least two or three

months before. Even at the time of procurement they ensure that they procure

much more than what actually is required by the firm that is they hold significant

amount of inventory as safety stock. This is done to counter the threat involved in
default and accidental breakdowns. The levels of safety stock usually vary

according to the usage.

Conversion Periods

Raw Material

Particulars 2008 2007 2006

Consumption 7 4
Raw Material 332 268.41 158.28

Consumption/da

y
 Raw Material 7072 6960.275 4364.73

Inventory 5
Raw Material 21 25.93 27.57

Holding Days

The raw material conversion period or the raw material holding cost has reduced from

26 to 21. This is despite an increase in its consumption. This indicates that the firm is

able to convert the raw material at its disposal to the work-in-progress at a lesser time

as compared to the last year. It would be to the benefit of the firm to reduce the

production process and increase the conversion rate still as the firm is required to meet

the increasing demand.

Work-in-progress

Particulars 2008 2007 2006

Production 1 9 3
Cost of 525.78 437.4 310.95

Production/da

y
Work in 689.5 827.52 679.455

progress

inventory
 WIP Holding 1.31 1.89 2.19

days

The work-in-progress holding time is important for a firm in the sense that it

determines the rate of time at which the production process will be complete or the

finished goods will be ready for disposal by the firm. The firm as it is in the process of

assembling should take the least possible time in conversion to finished goods unlike a

hard core manufacturing firm, as any firm would like to have its inventory in the work-

in-progress at the minimum. There would also be less of stock out costs as due to

better conversion rates the firm is able to meet the rise in demand situations. More the

time it spends lesser its efficiency would be in the market. Here the firm has been able

to bring down its WIP conversion periods.

Finished Goods

Particulars 2008 2007 2006

goods sold 7 5 2
Cost of 625 488.87 341.832

goods

sold/day
Finished 10310 6875.725 5026.505

goods

inventory
Finished 16 14.06 14.8
 goods

inventory

Holding

days

The time taken for the firm to realize its finished goods as sales has increased as

compared to last year. This growth in sales could be traced back to the growing

domestic IT market for the commercial as consumer segment in India. NTPC has

around 15% of the market in desktop and it is the market leader in this segment. So it

is only natural that they are able to better their conversion rate of finished goods to

sales.

Operating Cycle

Particulars 200 200 200

8 7 6
Inventory conversion 38 42 45

period
Average collection 70 63 66

period
Gross operating cycle 108 105 111
Average payment period 22 23 17
Operating cycle 86 82 94
The operating cycle of the firm reveals the days within which the inventory procured

gets converted to sales or revenue for the firm. This time period is of importance to the

firm as a lag here could significantly affect the profitability, liquidity, credit terms, and

the policies of the firm. All the firms would like to reduce it to such extend that their

cash inflows are timely enough to meet their obligations and support the operations.

That the firm has been able to reduce the ratio is in itself an achievement as they were

having huge stocks of inventory. But the reduction in the cycle could also be attributed

to the boom in the market and the growth it is expected to reach. This boom

automatically ensures the demand for the finished goods and thus helping in it to

garner sales for the firm.

Raw Material Consumption

Particulars 2008 2007 2006

7 7 3
Indigenous 2907 27187.0 15645.5

0 4 1
% Imports 75.99 72.25 72.92

A major chunk of the imports come from Korea and Taiwan and is purchased in US$.

The value of imported and indigenous raw material consumed give a clear picture that

if there is a change in the EXIM policy of the government it is bound to affect the
company adversely as more than 70% of their consumption is from imports. But this is

the scenario witnessed in the industry as a whole and though NTPC is into expanding

its operation to Uttaranchal it in the present state is would be affected by a change in

the import duty structure.

A major chunk of their current assets are in the form of inventory and the

change in technology will invariably be a threat faced by the firm. The

question of technology applying here like says a certain device going say out

of fashion or outdated. For e.g. TFT monitors being in demand more than

CRT.