2.workingcapitalmanagementfmcg.docx

A STUDY OF WORKING CAPITAL MANAGEMENT AND ITS IMPACT ON PROFITABILTY AND NETWORTH OF CNX FMCG INDEX COMPANIES Paper by: Riyazahmed.K, Assistant Professor, Department of MBA, Sona College of technology, Salem. ABSTRACT Optimal management of working capital is an important financial decision and contributes positively to the value creation of business. Every business needs investment to procure fixed assets, which remain in use for a longer period. Money invested in these assets is called ‘Long term Funds’ or ‘Fixed Capital’. Business also needs funds for short-term purposes to finance current operations. Investment in short term assets like cash, inventories, debtors etc is called ‘Short-term Funds’ or ‘Working Capital’. The ‘Working Capital’ can be categorized, as funds needed for carrying out day-to-day operations of the business smoothly. The management of the working capital is equally important as the management of long-term financial investment. It is also concerned with maintaining liquidity in the business to ensure smooth running of day to day operations and to meet its financial obligations. The role of finance manager, therefore, is a very vital and vested with responsibility of maintaining the business operations in an efficient and profitable manner. Mismatch, if any in effective management of current assets and current liabilities would not only result negative impact of profitability and firm’s growth but also financial distress and bankrupt of business entity. This study considering the significance of the above, shall make an attempt to investigate the efficiency of working capital management of FMCG companies listed in CNX FMCG INDEX and its relationship with profitability and net worth. Further, the study would also overcome limitation of scholastic knowledge due to dearth of research in financial management at the FMCG sector.

1. Introduction Every running business needs working capital. Even a business which is fully equipped with all types of fixed assets required is bound to collapse without (i) adequate supply of raw materials for processing; (ii) cash to pay for wages, power and other costs; (iii) creating a stock of finished goods to feed the market demand regularly; and, (iv) the ability to grant credit to its customers. All these require working capital. Working capital is thus like the lifeblood of a business. The business will not be able to carry on day-to-day activities without the availability of adequate working capital. Working capital cycle involves conversions and rotation of various constituents/ components of the working capital. Initially ‘cash’ is converted into raw materials.

Subsequently, with the usage of fixed assets resulting in value additions, the raw materials get converted into work in process and then into finished goods. When sold on credit, the finished goods assume the form of debtors who give the business cash on due date. Thus ‘cash’ assumes its original form again at the end of one such working capital cycle but in the course it passes through various other forms of current assets too. This is how various components of current assets keep on changing their forms due to value addition. As a result, they rotate and business operations continue.

Thus, the working capital cycle involves rotation of various constituents of the working capital. While managing the working capital, two characteristics of current assets should be kept in mind viz. (i) short life span, and (ii) swift transformation into other form of current asset. Each constituent of current asset has comparatively very short life span. Investment remains in a particular form of current asset for a short period. The life span of current assets depends upon the time required in the activities of procurement; production, sales and collection and degree of synchronization among them. A very short life span of current assets results into swift transformation into other form of current assets for a running business. These characteristics have certain implications: i.

Decision regarding management of the working capital has to be taken frequently and on a repeat basis.

ii.

The various components of the working capital are closely related and mismanagement of any one component adversely affects the other components too.

iii.

The difference between the present value and the book value of profit is not significant.

The working capital has the following components, which are in several forms of current assets: 

Stock of Cash



Stock of Raw Material



Stock of Finished Goods



Value of Debtors



Miscellaneous current assets like short term investment loans & advances

The working capital needs of a business are influenced by numerous factors. The important ones are discussed in brief as given below:

i. Nature of Enterprise The nature and the working capital requirements of an enterprise are interlinked. While a manufacturing industry has a long cycle of operation of the working capital, the same would be short in an enterprise involved in providing services. The amount required also varies as per the nature; an enterprise involved in production would require more working capital than a service sector enterprise. ii. Manufacturing/Production Policy Each enterprise in the manufacturing sector has its own production policy, some follow the policy of uniform production even if the demand varies from time to time, and others may follow the principle of 'demand-based production' in which production is based on the demand during that particular phase of time. Accordingly, the working capital requirements vary for both of them.

iii. Operations The requirement of working capital fluctuates for seasonal business. The working capital needs of such businesses may increase considerably during the busy season and decrease during the slack season. Ice creams and cold drinks have a great demand during summers, while in winters the sales are negligible. iv. Market Condition If there is high competition in the chosen product category, then one shall need to offer sops like credit, immediate delivery of goods etc. for which the working capital requirement will be high. Otherwise, if there is no competition or less competition in the market then the working capital requirements will be low. v. Availability of Raw Material If raw material is readily available then one need not maintain a large stock of the same, thereby reducing the working capital investment in raw material stock. On the other hand, if raw material is not readily available then a large inventory/stock needs to be maintained, thereby calling for substantial investment in the same.

vi. Growth and Expansion Growth and expansion in the volume of business results in enhancement of the working capital requirement. As business grows and expands, it needs a larger amount of working capital. Normally, the need for increased working capital funds precedes growth in business activities.

vii. Price Level Changes Generally, rising price level requires a higher investment in the working capital. With increasing prices, the same level of current assets needs enhanced investment.

viii. Manufacturing Cycle The manufacturing cycle starts with the purchase of raw material and is completed with the production of finished goods. If the manufacturing cycle involves a longer period, the need for working capital would be more. At times, business needs to estimate the requirement of working capital in advance for proper control and management. The factors discussed above influence the quantum of working capital in the business. The assessment of working capital requirement is made keeping these factors in view. Each constituent of working capital retains its form for a certain period and that holding period is determined by the factors discussed above. So for correct assessment of the working capital requirement, the duration at various stages of the working capital cycle is estimated. Thereafter, proper value is assigned to the respective current assets, depending on its level of completion. The basis for assigning value to each component is given below:

CONSEQUENCES OF UNDER ASSESSMENT OF WORKING CAPITAL 

Growth may be stunted. It may become difficult for the enterprise to undertake profitable projects due to non-availability of working capital.



Implementation of operating plans may become difficult and consequently the profit goals may not be achieved.



Cash crisis may emerge due to paucity of working funds.



Optimum capacity utilization of fixed assets may not be achieved due to non-availability of the working capital.



The business may fail to honor its commitment in time, thereby adversely affecting its credibility. This situation may lead to business closure.



The business may be compelled to buy raw materials on credit and sell finished goods on cash. In the process it may end up with increasing cost of purchases and reducing selling prices by offering discounts. Both these situations would affect profitability adversely.



Non-availability of stocks due to non-availability of funds may result in production stoppage.



While underassessment of working capital has disastrous implications on business; over assessment of working capital also have its own dangers.

CONSEQUENCES OF OVER ASSESSMENT OF WORKING CAPITAL 

Excess of working capital may result in unnecessary accumulation of inventories.



It may lead to offer too liberal credit terms to buyers and very poor recovery system and cash management.



It may make management complacent leading to its inefficiency.



Over-investment in working capital makes capital less productive and may reduce return on investment. Working capital is very essential for success of a business and, therefore, needs efficient management and control.



Each of the components of the working capital needs proper management to optimize profit.

Rationale of the study: Every business intends to maximize their shareholders worth through several financial management techniques. This objective of business enterprise will be achieved only when it earns reasonable profits from its operations. As profits are depending upon the volume of sales, these sales may not result in immediate conversion of stock into cash. The business enterprises, therefore, should maintain reasonable working capital for smooth running of its day to day operations. This short term financing decision should be accurately match between profitability and liquidity. Any mismatch in effective management of current assets and current liabilities would not only result negative impact of profitability and firm’s growth but also financial distress as well as bankrupt of business entity. This study, considering the significance of

above, shall make an attempt to study the management of working capital management of FMCG companies in CNX FMCG INDEX and tries to investigate the relationship between working capital and profitability of the FMCG companies. This study expected to contribute to existing literature on working capital and FMCG companies in India.

The objectives of the study are designed to examine the working capital management at selected companies and in particular 

The ascertain the efficiency of working capital management of FMCG companies



To analyze the impact of working capital components on profitability.



To examine the effect of working capital on net worth

Review of literature: .

JP singh and shishir pandey (2008) studied on the impact of working capital on

profitability through correlation between liquidity, profitability and profit before tax (PBT) of hindalco industries limited based on secondary data from annual reports for the period 1990 to 2007. F Samiloglu and K Demirgunes (2008) analysed the effect of working capital management on firm profitability by considering significant relationship between firm profitability and the components of cash conversion cycle. The study used regression model to measure statistical significance. Empirical findings of the study showed that, the accounts receivable period, inventory period and leverage affect firm negatively. While growth affect firm profitability positively. Pedro Juan Garcia terurel and pedro Martinez Solano (2007) studied on the effects of working capital management on profitability of small and medium sized Spanish firms. The study found that managers can create value by reducing the inventories and the number of days for which their accounts are outstanding. Further, it is found that shortening the cash conversion cycle as the firm’s profitability. Marc Deloof (2003) investigated the relationship between working capital management and corporate profitability at Belgian non financial firms through measuring trade credit policy and inventory policy by number of days account receivable, account payable and inventories, and the cash conversion cycle. This study found that less profitable firms wait longer to pay their bills. S Benjamin Christopher studied on sensitivity of profitability to working capital management using dependent variable, as a return on investment to measure profitability and to ascertain relationship between working capital Management and profitability. The study found significant relationship with ROI through

correlation analysis. Further empirical data through regression analysis found that and increase of one unit in current ratio, cash turnover ratio, current assets to operating income and leverages decreases profitability. Further the path analysis of study reveals that, the effect of quick ratio has the highest direct effect o profitability while current ratio has the least direct effect. Zariawathi , MA Annuar M.N Abdul Rahim observed the effect of working capital management on profitability of the firms in Malaysia. The study used the regression analysis and revealed the strong negative relationship between cash conversion cycle and firm profitability. The study found that reducing cash conversion period would result in increase of profitability. The above literature of working capital management facilitates the study to understand methodology and findings on different aspects. The study also noted lack of scholastic work in FMCG sector. Based on the same, the study developed methodology of its own for the specific research.

Research Methodology: The study focused to address the efficiency of working capital management of FMCG companies listed in CNX NSE FMCG Index. The companies included in FMCG index are listed below;               

Brittania Industries Colgate polmolive Dabur India Emami Ltd Glaxosmithkline consumer Godrej consumer Hindustan unilever ITC lmt Jubiliant foodworks Marico Ltd Mcleod russel Rei Agri ltd Tata global beverages United breweries United spirits

The above mentioned 15 companies are listed in National Stock Exchange (NSE). The study used secondary data from published financial statements for a period of five years i,e from 2006-07 to 2010-2011. Variables used for data analysis:

The study identified independent and dependent variables based on the earlier research studies in the area of working capital management. These are used tot test hypothesis of the study. 

Current ratio establishes the relationship between current assets and current liabilities. Normally, high current ratio is considered to be a sign of financial strength. It is the indicator of the firm’s ability to promptly meet its short term liabilities.



Quick ratio (Acid test ratio) establishes a relationship between quick or liquid assets and current liabilities. Liquid assets can be converted into cash immediately without ay loss of value. Cash is the most liquid assets.



Inventory turnover ratio is the number of times inventory turned over in a year. It is the relationship between cost of goods sold and average inventory at cost.



Fixed assets turnover ratio is the ratio of sales to the value of fixed assets. It indicates how well the business is using its fixed assets to generate sales. Generally, the higher the ratio, the better, because a high ratio indicates the business has less money tied up in fixed assets for each rupee of sales revenue. A declining ratio may indicate that the business is over invested fixed assets.



Return on Net worth (Return on Equity) measures the rate of return on the ownership interest (shareholder’s equity) of the common stock owners. It measures a firm’s efficiency at generating profits from every unit of shareholder’s equity (also known as net assets or assets minus liabilities). ROE shows how well a company uses investment funds to generate earning growth.



Net profit margin refers to measure of profitability. It is calculated by finding the net profit as a percentage of revenue. The profit margin is mostly used for internal comparison. It is difficult to accurately compare the net profit ratio for different entities. Individual business’ operating and financing arrangements vary so much that different entities are bound to have little meaning. A low profit margin indicates a low margin of safety; higher risk that a decline in sales will erase profits and results in a net loss.

Analysis & Interpretation: 1. Working Capital management efficiency: The following are the working capital ratios of the 15 companies in the CNX FMCG Index:

CNX FMCG INDEX Brittania Industries Colgate polmolive Dabur India Emami Ltd Glaxosmithkline consumer Godrej consumer Hindustan unilever ITC limited Jubiliant foodworks Marico Ltd Mcleod russel Rei Agri ltd Tata global beverages United breweries United spirits

Inventory NP Turnover Debtors turn Margin RONW FATR CR QR ratio ratio 4.94 25.554 7.482 1.156 0.574 13.318 77.298 16.214 25.554 4.408 0.99 0.738 15.674 15.972 14.842 55.926 5.344 0.998 0.732 10.906 26.312 14.834 30.078 2.354 1.502 1.782 12.278 14.976 11.716 16.624 12.692 21.658 6.21 9.948 13.592 5.728

26.046 59.754 97.054 27.286 32.13 45.886 17.414 16.154

3.432 5.814 7.578 1.744 2.26 7.698 0.576 5.674

1.666 1.26 0.806 1.222 0.79 1.17 0.48 0.652

1.116 0.83 0.398 0.528 0.69 1.16 0.612 4.696

8.556 7.522 8.276 5.324 76.83 7.486 35.726 1.102

49.264 73.616 30.436 22.152 23.23 30.674 41.436 4.252

18.46 4.342 9.682

14.892 9.404 15.462

7.17 2.718 5.34

0.692 1.63 1.82

0.754 2.736 3.784

5.424 16.752 12.952

17.324 5.004 7.404

From the above mentioned ratios, in Net profit margin ITC limited have a highest net profit margin followed by Tata global beverages. In return on net worth (RONW) Godrej consumer comes second next to Hindustan lever (97.054). Fixed assets turnover for Marico and Britannia industries are found to be higher than the industry competitors. Current ratio and quick ratio of united spirits and Rei Agri ltd are higher than the industry competitors. Inventory turnover and debtors turnover higher In Jubilian food works are higher than the industry counter parts.

2. Ratios of the selected companies for the period of 5 years:

Net profit Margin Return on Net worth Fixed Assets turnover ratio Current ratio Quick ratio Inv. Turnover ratio Debtors Turnover ratio

2011 12.61266667 35.44533333 4.67 1.102 1.471333333 15.47 45.54933333

2010 2009 2008 2007 13.08 10.20866667 11.86333333 11.90133333 29.036 37.73533333 44.12533333 36.31666667 4.326666667 1.153333333 1.749333333 17.786 54.03066667

4.468666667 1.132666667 1.302666667 16.53333333 56.45

4.377333333 0.993333333 1.212666667 10.73733333 36.90333333

5.053333333 1.125333333 1.215333333 8.605333333 38.21933333

Net profit margin considerably increased till the year 2010 and slightly decreased in 2011. Return on net worth increased till 2009 and decreased in 2010, started increasing in 2011.Fixed assets turnover ratio showing decreasing trend over 5 years. Current ratio, Quick ratio, debtor’s turnover ratio showing stable trend the past 5 years. Inventory turnover ratio is showing a raising trend over the five years.

3. Relationship between profitability, net worth and working capital:

Pearson Correlations NPM NPM

Pearson Correlation

RONW

FATR

CR

QR

INV

1

Sig. (2-tailed) N RONW

Pearson Correlation Sig. (2-tailed) N

FATR

1

.383 5

-.030

.004

.962

.995

5

5

5

Pearson Correlation

.047

-.865

.223

Sig. (2-tailed)

.941

.058

.718

5

5

5

5

Pearson Correlation

.643

-.858

-.450

.541

Sig. (2-tailed)

.241

.063

.446

.346

Pearson Correlation

N

N QR

-.507

5

Sig. (2-tailed)

CR

5

1

1

1

DEB

N INV

5

5

5

5

5

Pearson Correlation

.080

-.592

-.642

.501

.776

Sig. (2-tailed)

.899

.293

.243

.390

.123

5

5

5

5

5

5

-.212

-.596

-.482

.686

.608

.910*

.732

.289

.411

.201

.276

.032

5

5

5

5

5

5

N DEB

Pearson Correlation Sig. (2-tailed) N

1

1

5

*Correlation is significant at the 0.05 level (2 tailed)

From the above correlation analysis Net profit margin is highly correlated with Quick ratio (0.643), and Return on Net worth is highly negatively correlated with Quick ratio and Current ratio. Current ratio is highly correlated (0.776) with Inventory turnover ratio. Debtors’ turnover ratio is highly correlated (0.910) with Inventory turnover ratio. Conclusion: The study therefore reveals that, Indian FMCG companies should give due importance for the short term asset management for improving the net profit margin. Further Return on net worth does not influenced by any of the short variables in the chosen companies. However, Inventory turnover is highly correlated with quick ratio, so improving inventory management efficiency will give improvement in profit; since quick ratio is highly correlated with Inventory and Net profit margin for the selected companies. In addition to the above, it is found from the empirical studies that, working capital management is an important tool to measure a company’s operational and financial efficiency. This should form a part of company’s operational and strategic plans. Further, every effort should be made to improve the working capital position and it will not only yield greater efficiency but also improve financial efficiency.

References 

Bhattacharya, Hrishikes (2001), working capital management – strategies and techniques, prentice hall of india private limited New Delhi,2001



Christopher,S. Benjamin & A.L Kamalavalli: Sensitivity of profitability to working capital management in Indian corporate hospitals.



Deloof, Marc (2003-04), Journal of Business Finance and Accounting, Vol.30, issue 3-4, pp 573-588



Since JP & shisher pandey (2008), Impact of working capital management in the profitability of Hindalco Industries Limited, The ICFAI university journal of Financial Economics, volume VI, pp 62 – 72.



A.N.Vijayakumar,(2010)

Impact

of

working

capital

management

on

profitability and net worth – A study on selected Indian Tea plantations companies, Sona global management research, volume 4,issue 3,pp 71-83.