After running as a family business for over 100 years, when in late 1990s, the management of the
XYZ was handed over to a team of professional managers, the new management faced a gigantic
task of improving performance in several critical areas. In particular, working capital and cost
management required urgent attention as the company’s performance in these areas had been far
from satisfactory. The then prevailing current ratio of 3:2 and quick ratio of 2:4 were considered
too high and indicative of heavy unnecessary investments in working capital that would have a
negative effect on company’s profitability.
Efforts to improve the working capital efficiency were met with stiff resistance from various
quarters, but finally yielded results. The case study discusses the measures taken to improve the
working capital and cost management performance, and how with concerted efforts the
management turned around a highly inefficient working capital management into one of the most
efficient in the FMCG sector of the Indian industry.
In fact, the company seemed to have taken the matter to the other extreme of negative working
capital, with the current ratio declining to 0:8 and the quick ratio to just 0.4 in 2004–05.
In 2005–06 as the company was ready to launch itself into the next phase of fast growth, several
critical issues related to the liquidity and solvency of the company confronted the management
which is also discussed in the case study.
Case Description:
‘How could a company have a “negative” working capital and call itself successful?’ Ram asked
his friend Shyam. They had just joined XYZ India as management trainees and at the moment
were having their lunch in the company’s staff canteen. Ram had spent the morning studying the
company’s balance sheets for the years 2003–04 and 2004–05 and was surprised to see that the
company’s current liabilities exceeded its current assets. He remembered reading in his text
books that such a situation indicated that the company could face difficulties in meeting its shortterm
liabilities. ‘I don’t know about that’, Shyam replied, ‘but I think it is a highly profitable
company’. ‘Sure, no problem with the company’s profitability. In fact the net profit in 2004–05
jumped by as much as 46 per cent to Rs 148 crore from Rs 101 crore last year’. ‘Wow, that’s a
lot of increase in one year,’ Shyam said, ‘in fact I am told that the company has an impressive
market share in its product line and is the fourth largest FMCG company in India. But if the
company is making high profits and has a good market share, then where is the problem?’ Ram
was ready with his reply, ‘The way I understand, that could be a common trap for the profitable
but fast growing companies. Liquidity and profitability are two separate issues and it is naïve to
assume that a profitable company would necessarily be liquid too. See, what happens is that in
order to provide finance for expansion and diversification projects, a company could cut down
on inventories, reduce the credit period to customers while at the same time seek extended credit
facilities from its suppliers of raw materials, other goods and services. Also, it tries to manage
with nil or as little cash in hand as possible. As a result, the current assets represented by
inventories, debtors and cash would be reduced and current liabilities represented by creditors
would increase, culminating in a situation when the company might not have enough current
assets to pay for its current liabilities if all creditors wanted them to be settled at once, what to
talk abouut leaving some surplus to continue with its normal business operations’. Ram said
emphatically.
XYZ India’s corporate office was housed in a beautifully landscaped, imposing six storied glass
building set on several acres of prime land at Kaushambi adjacent to New Delhi. ‘Well, if the
company can make its working capital more efficient, I don’t see anybody should have a
problem with that. But don’t forget we have an orientation meeting with the finance department
in a little while from now’.
Ram was too engrossed with his own thoughts to be affected by such interruption, and
continued, ‘The traditional wisdom of having a positive networking capital means that at least
some part of the working capital finance should come from the company’s long term sources so
that at any time, even if the company has to settle all its current liabilities at once, it would still
be left with some minimum current assets with which it could continue to do its normal business.
In technical terms, they say a company needs some permanent working capital and a fluctuating
working capital. From what I have read, ideally the permanent working capital and maybe some
part of the fluctuating working capital also should be financed out of the company’s long-term
sources in order to ensure good liquidity and avoid the threat to its solvency’.
Shyam looked at his watch, ‘My friend, times are changing. Reduction in inventory and debtors
could as well be a management strategy. The Japanese have shown the world how to manage
with zero inventories. As far as debtors are concerned, when a firm can sell on cash or near cash
terms, why should it sell on credit just to make the balance sheet fit in to your traditional
wisdom? Modern enterprises have to be efficient, lean and mean, if we could put it that way, to
remain competitive’.
Ram did not like this argument and said, ‘You don’t get the point, do you? Once a company
defaults on payment of any of its current liabilities, the word spreads like wild fire and affects the
company’s image and credit rating. With lower credit rating, not many lenders would come
forward if it wanted to borrow more, and even if they do, it would cost the company dearer. All
this might just start a roller coaster the company might not have bargained for’.
Shyam did not like Ram’s habit of lecturing, and firmly said, ‘Ram, come out of the text books. I
think there’s more to liquidity than just the ratio of current assets and current liabilities’. Then
getting up he said, ‘Any ways, let’s not be late for the orientation meeting. We can continue with
our discussion later on’.
The stage was already set for the orientation meeting by the time Ram and Shyam walked in.
The meeting had a touch of professional perfection and was more detailed and thorough than
they had anticipated. Mr. Singh Additional GM—Financial Planning, made an impressive
PowerPoint presentation and dealt with many aspects including the company’s history, handing
over of the management to professional team, current challenges and future strategy. Some
PowerPoint slides are reproduced in the annexure.
The Company
The story of XYZ began with a visionary endeavor by Dr S.K. Bose to provide effective and
affordable natural cures for the killer diseases of those days like cholera, malaria and plague for
ordinary people in far-flung villages in Bengal. Soon Dr Bose became popular for his effective
cures. Dr. Bose set up XYZ in 1884 to produce and dispense Ayurvedic medicines, with the
vision of good health for all.
More than a century later, by 1990s XYZ had grown manifold. Over the years, the family has
understood the need for incorporating a professional management team that would be able to
launch XYZ onto a high growth path in the emerging competitive environment. Therefore, in
1998, the Bose family started handing over the management of the company to professionals and
down scaled its direct involvement in day-to-day operations.
In 2003, with the approval of the Delhi High Court, the company demerged its pharmaceutical
business to a new company, XYZ Pharma Limited, to ‘unlock value in both pharma & FMCG
business’. As a result, the entire pharma business was transferred to the said company.
By 2005, XYZ India had emerged as a leading nature-based health and family care products
company with eight manufacturing units, 5,000 distributors and over 1.5 million retail outlets
spread all over India and abroad. XYZ crossed a turnover of Rs 1, 000 crores in year 2000–01,
and further Rs 1,300 crore in 2004–05; thereby establishing its market leadership in its line of
activity.
Its main product lines include:
• Hair-care
• Health supplements
• Digestives and confectionaries
• Oral care
• Baby and skin care
The New Management
With the professional management team taking over in 1998, there was a significant change in
the focus, approach and strategy of managing the company. Earlier, the company used to focus
mainly on bottom line growth, that is, on improving the profits, while the new management
stressed on improving efficiency and performance in all areas. With the help of management
consultants from Mckinsey, the company changed its organizational structure for better
responsibility accounting. Various departments were introduced / rationalized including the
supply-chain, sales and marketing, purchase/ procurement etc and their functions were clearly
defined. The planning and budgeting activity was strengthened, performance oriented incentives
were put in place and the finance department was made the custodian of all MIS.
The finance department instituted a system of regular comparative evaluation of the company’s
performance vis-à-vis other FMCG competitors using detailed financial ratios analysis; this
aspect was somehow not given due importance in the earlier management regime.
The main idea behind introducing such changes was to improve not only the bottom-line of the
company but to induce competency in all functional areas. One area which the new management
considered as full of potential was the management of working capital. A lot of investment
seemed blocked in inventories and debtors, which was pulling down the overall return on capital
employed (ROCE). There was an opportunity and a need to trim down investment in this area.
Therefore, the company focused on reducing the working capital needed for the operations. The
company set a target of achieving zero networking capital by year 2000–01 and aimed at further
reducing it to negative levels in the long term. A number of initiatives were taken to reduce the
cost of different components of working capital. However, it was not an easy task as the
management faced stiff resistance and opposition from its bulk customers and stockists, suppliers
of raw materials and other services, as well as internal departments.
Inventory Management and Cost Reduction
Given the large variety of products that are manufactured and marketed, and hundreds of
different raw materials used by the company, accurate forecasting of inventory is very important
for effective working capital management. A wrong forecast can lead to piles of inventory, thus
blocking unnecessary investment and increasing storage cost as well as the risk of damage
associated with perishable items. After the new management took over, an inventory
management system was instituted involving all related departments like procurement,
manufacturing, marketing, sales and supply chain. The finance department is involved
throughout the process and helps in linking all operations and controlling flow of information
through various departments.
The annual planning process begins in November–December each year with the objective of
finalizing the company’s annual budget, before the start of the next accounting year from April.
The sales targets for the forthcoming period are set by MANCOM (Management Committee),
which comprises the heads of functional areas like Sales, Marketing, Human Resource,
Commercial, Supply chain, and Production and Finance taking the company’s product-packaging
mix of approximately one thousand (1,000) SKU’s (Stock Keeping Units) into consideration.
The sales targets take into account the sales trends and special promotion schemes. On the basis
of sales targets set for the forthcoming period, the sales department establishes product-wise
requirements of the finished goods. This information is used by the production department to
prepare a rolling production plan and establish the quantity of each type of raw material required
for meeting the production targets. This information on raw material requirements is then
communicated to the purchase/procurement department.
As the production department itself establishes the requirements of raw materials to be
purchased, it prevents excess purchases and helps in reducing the storage cost as well as the cost
of funds blocked in inventories. For each item purchased, a safety stock is identified and
maintained to take care of any fluctuations in lead-time and usage of raw materials before fresh
supplies would arrive. Suitable safety stocks are maintained for finished goods too. Raw
materials have been classified on the basis of value, quantity required and location of
procurement. While purchases of more valuable items are taken care of by the central
procurement unit, low-value and/or low-number items may be locally purchased on a
decentralized basis. The main aim is to minimize the cost of the raw materials including
transportation cost. Specialized professionals (called Category Managers) are appointed to look
after the procurement of various types of raw materials.
As far as possible, the company procures materials on back-to-back basis following the Just-in-
Time (JIT) approach. However, JIT inventory system is not applicable for all inputs. Many of its
inputs are agricultural products that are available at cheaper prices seasonally when fresh crops
arrive into the market. If the annual requirement of raw materials is not purchased/tied-up during
this period, the company may have to pay much higher prices which could rise by as much as 50
per cent to 75 per cent in the off-season months. As a result, the company must procure such raw
materials within the period of their seasonal abundance (typically just 45– 65 days) and preserve
them for later use. Often, enough stocks are procured to partly use them in the current year (40
per cent) and partly (60 per cent) next year.
Fortunately, with the start of the Commodities Exchange in India, the company has an alternative
way of managing raw material cost, and that is by taking a position in the derivatives (futures
and options) market. For example, suppose the company can buy a call option for 1 million kg of
material X at an exercise price of Rs 15 per kg with a maturity of 3 months. The call option gives
the company a right (but not obligation) to buy the stated quantity of X at the agreed exercise
price. To buy a call option the company will have to pay a cost, called premium (say Rs 0.50 per
kg), but at the same time the call option will hedge it against possible losses if the market price
of X rises beyond the exercise price before the maturity of the option.
For example, if the price of X rises to Rs 18 per kg, the company will find it advantageous to
exercise its option to buy it at Rs 15. Usually, the company enters into futures and options
contracts for periods ranging from 3 to 9 months. Hedging combined with e-procurement has
significantly helped the company in cost control and reduction. According to the CFO,
Mr R. Varma, ‘We managed to cut costs through our e-procurement system. We as a company
may or may not have control over commodity prices, but our marketing and purchase guys are
taking futuristic positions and even though this practice constitutes a business risk it is beginning
to show results’.
Another significant tool of cost reduction used by XYZ India is ‘value engineering’ to identify
and develop more cost effective materials. For example, this has resulted in reducing the cost of
packaging for several of the company products. Research and development activities have also
helped in reducing the time of processing which has increased productivity. In nonmanufacturing
areas too, the company has been looking for opportunities to cut down the costs.
In 2003, the company applied for and got the court approval for de-listing of its shares from
several regional stock-exchanges including Ahmedabad, Bangalore, Delhi, Jaipur, Ludhiana,
Magadh and Uttar Pradesh stock exchanges. The trading volumes of the company’s shares at
these stock exchanges had been negligible for many years and by de-listing its shares from these
regional stock exchanges, the company saved itself from considerable costs as well as regulatory
provisions.
Debtors Management
The company has mainly three types of customers: stockists, institutions and international/
export customers. The company does not have a standard credit policy that could be applied to
all customers. Instead, distinct credit terms are offered to each group depending upon various
factors such as the product, place, price, demand and competition.
1) Stockists: In 2005, the company had about 1.5 million stockists. The credit terms to the
stockists vary from 1–10 days depending upon factors stated above as well as their locations visàvis
the depot towns. Depot towns are mostly the state capitals or other commercial towns/cities
where the company has its own sales depots operating.
• Stockists in town depots: 70 per cent of the company’s stockists are located in or around the
depot towns. At these places, the company uses the Cash Management System (CMS) offered by
banks; stockists’ cheques collected till the end of a day are deposited next morning into the
company’s local bank account from where the funds are transferred to the corporate bank
account. Earlier these stockists used to enjoy five days credit period but now the company has
decreased the time frame to one day. For new stockists, sales are normally made through demand
drafts. If a stockist’s cheque bounces, then the party has to make payment only by demand-draft.
If a party defaults on payment (or a party’s cheques bounce) more than once, then for all its
transactions with XYZ India in the coming year, the party would be required to make payments
only by demand-drafts.
• Stockists in remote areas: The rest 30 per cent of the turnover with stockists takes place at
remote places away from depot towns with no easy access to banks so that the ‘anywhere
cheque’ system is logistically not possible. Such stockists may be allowed a credit period of up
to 10 days. On the average, the money is credited in company’s bank account in 3–7 days.
2) Institutions: Institutions like canteen stores department (CSD), large stores, hotels and
modern malls are offered soft payment terms that may range from 15 to 90 days. Though such
institutions are slower in making payments, the higher profit margins on such sales more than
make up the cost of extended credit.
3)International Customers: Similarly, credit terms negotiated with export customers would
depend on the international competition and product pricing.
Where longer credit terms must be offered as a part of the marketing strategy, the company often
resorts to ‘factoring’ as a means of financing debtors. The factoring arrangements are made with
banks or specialized factoring companies. In these cases, the company makes sure that profit
margins from such sales are high enough to cover the cost of factoring.
Cash Management
As stated above, the company maintains bank accounts at all depots towns. Cheques/ drafts
received from customers in nearby places are sent for local clearing to initially collect funds in
these bank accounts. This reduces the average collection period (as compared to the time it
would take if customer cheques were first received at head-office and then sent for out-station
clearing); thereby increasing the velocity of cash inflows. Funds thus collected at the depot
towns are each day transferred to the company’s head-office (or corporate) bank account. The
company has a ‘sweeping arrangement’ with the bank at head-office by which any funds
transferred from the depot towns are automatically applied towards settling the company’s cash
credit loan from the bank and reducing its debit balance. These steps have resulted in reducing
and controlling the cost of interest to the company. When the company has surplus funds, the
company invests the same in short-term investments or instruments like mutual funds and
government securities.
Suppliers
The company has more then 1,000 suppliers inclusive of service providers like advertisement
companies. Out of these, 100–150 are regular suppliers. Most suppliers are small business units
with annual trading volume of Rs 2–3 crore with XYZ India. The company enjoys credit periods
ranging from seven to 90 days from the creditors, which can at times be extended up to 120 days.
The suppliers use the bills discounting to avail bank financing against their receivables from
XYZ India and bear the bank charges as well. However, if the credit period is extended beyond
120 days, the bills discounting charges are borne by XYZ India.
Financing Working Capital
The company makes an aggressive use of all ethical means to increase the velocity of cash
inflows from customers and tries to slow down the cash outflows to creditors. Credit facilities
from suppliers of raw materials, other goods and services are therefore the main sources of
financing working capital. However, it has not been easy for the company to negotiate favorable
terms with its debtors and creditors. The XYZ management spends considerable time and effort
to train debtors and suppliers in modern ways of financing such as factoring or bills discounting,
and helps them by bank introductions etc. When a policy change in credit terms seems necessary,
it is first negotiated with the big creditors and debtors before being implemented for all suppliers
and customers. Discussions with suppliers take place in a highly transparent manner. Among the
methods used to control credit are techniques such as regression, progression, slap or
standardized terms. The management identifies and bridges the communication gaps through
educating the suppliers.
Supply Chain Management
The supply chain management in XYZ India is a key factor impacting sales, profitability and
working capital. Exhibit 1 shows the supply chain flowchart.
An efficient supply chain system helps in value creation for the business in four important ways.
These are: (i) Positive impact on sales: created by improved service through reliable and regular
flow of quality goods to retailers and end-use customers. (ii) Reducing investment in inventories
and increasing accounts payables, (iii) Cost management: lower inventory levels result in lower
carrying cost, which is approximately 10 per cent per annum on the average inventory held.
Thus, if inventory holding reduces by Rs 10 million, it will lead to a saving in carrying cost of
about Rs 1 million per annum. Cost savings also result from the better coordination between
inventory planning, acquisition and usage departments and (iv) Facilitating optimum use of the
firm’s fixed assets and infrastructure by increasing inventory turnover.
Role of the Finance Department
The finance department is involved in all aspects of financial planning and control. It maintains a
quarterly score card, which helps the company to evaluate the performance of employees in
terms of cost to company (CTC). Managerial remuneration consists of a fixed salary plus
bonuses based on performance on a variety of parameters including maintenance of inventory
levels and other working capital items within agreed limits. The department also prepares MIS
and communicates the same to all the concerned departments. It also continuously monitors the
management of inventory, debtors and creditors to ensure that the net working capital remains
within the budgeted levels. If, for example, the investment in inventory exceeds the planned
limits due to some unavoidable circumstances, it must be offset by either an increase in creditors
or a reduction in debtors. The orientation meeting was coming to a close. The AGM concluded
by saying, ‘Ever since the professional management took over the reigns of the company, efforts
have been made to upgrade efficiency in all aspects of business to build a competitive edge and
improve the return on investment. I may add here that, in my personal opinion, the balance sheet
as per the current provisions of the Companies Act does not show a true picture of the
company’s liquidity. This is because the company’s investment in marketable securities is at
present not allowed to be included in the current assets. Therefore, the company actually has a
better liquidity position than reflected by the net working capital as shown in the balance sheet.’
Ram was so absorbed in the presentation that he remained seated even after it was over and
others started leaving the small but well furnished conference hall. He was shaken out of his
thoughts when he heard Shyam, ‘Wow, I didn’t know managing working capital involved so
many aspects. What do you think?’ ‘Well, definitely it has been a learning experience. I guess I
have to start analyzing the company performance all over again. To fully understand the
evolving financial strategy, may be I should begin with a comparative analysis of XYZ India’s
performance against its competitors, say HLL, for some years before and after 1998 when the
change in management took place’. Ram said as they followed others out of the hall.
Discuss
1. Assume this is 1998–99. The new management wants to identify areas with potential for
improving performance, particularly in the area of working capital. For this purpose, taking
HLL’s financial performance as a benchmark, carry out a financial statement analysis for
XYZ India for the period 1995 to 1998, and identify the areas where there is need for
improving performance. Use the summarized data in Exhibits 2 and 3 for this purpose.
2. Using data in Exhibit 4, calculate various working capital ratios for XYZ India for the years
2003–04 and 2004– 05. Compare these with similar ratios for the years 1995 to 1998. Identify
the trends and discuss their implications on working capital management.
3. Are you convinced with the claim made by the management regarding the working capital
performance of XYZ India? Back your arguments with suitable facts, figures, and analyses.
4. What do you think are the advantages and disadvantages of a ‘negative’ net working capital
policy? If you are the CFO of a company, which policy would you like to follow and why?
5. What is the importance of cost control and reduction in the emerging business environment?
Using XYZ India’s experience as an illustration, discuss the techniques or methods that a
company could use to reduce costs.
6. Using internet and other available sources collect latest financial information on five major
competitors in the FMCG sector and carry out a detailed analysis of the working capital
management covering as many aspects as possible.
7. What according to you should be the financing policy of the company in the present scenario?
Justify your claim.
