Working Capital Management - Cytec Industries - Essay Example

Finance and Strategy Contents Contents 2 Introduction 4 Working Capital Management 5 Working Capital 5 Working Capital Cycle 6 Cash conversion cycle 6 Poor Working Capital Management leads to Corporate Failure 6 Strategic reasons 7 Financial Reasons 8 Strategic and Financial reasons leading to Corporate Failure 10 Effective Working Capital Practices 14 The Case of Cytec Industries 16 Key factors affecting Cytec’s working capital position 16 Cytec’s working capital practices 16 The Case of Global Aerospace Corporation 17 Key factors affecting Aerospace Corporation’s working capital position 17 Aerospace Corporation’s Working Capital Practices 17 Conclusion 19 References 20 Introduction The project report aims to find how poor working capital management leads to corporate failure. It considers the strategic and financial reasons of failure affecting the cash flows of corporate entities. The report cites various examples of companies that are failing due to poor working capital management and outlines the reasons for such failure. It concludes by stating effective working capital practices that will lead to effective and efficient short term capital management. Poor working capital practices can at times adversely affect the business operations leading to corporate failure. Working capital management is a keystone that determines the short term solvency position of the company. It shows the ability of the firm to meet its short term obligations with its short term resources. Usually it is required to pay off the suppliers, purchase raw materials, wages and other direct expenses related to the core business operations. It ensures the business perpetuity and sustainability (Matz, 2011). Working Capital Management Working Capital It is the difference between short term assets/ current assets and short term liabilities/ current liabilities. Working capital means net current assets i.e. when the current assets exceed current liabilities. A company is expected to have sufficient working capital to meet its current obligations; else it signifies a weak short term solvency position. Working capital includes the following items (Spurga, 2004): Short term assets (Alleman, 2012) Cash and bank balances Accounts receivables Marketable securities ( Short term investments) Inventory Short term liabilities (Alleman, 2012) Accounts payable Other accounts payable ( payable within a year) Short term loans Working Capital Cycle It is the time taken to convert the short term assets into cash to meet its short term liabilities. A longer cycle time means that a company takes long time to convert its current assets. For example, company X has a supplier payment period of 30 days and collection period of 60 days. Its working capital cycle is 30 days, resulting in a deficit of 30 days that needs to be financed through short term loans. Companies should aim to reduce its working capital cycle in order to reduce its cost of short term borrowing that impacts the income statement and balance sheet (Periasamy, 2009). Cash conversion cycle The cash conversion cycle measures the cash to cash cycle. Business’ use cash to buy inventory, and produces goods which are sold in the market to earn cash. The measure of the time taken for employment of cash to earn cash is the cash conversion cycle. A longer cycle is significant of longer collection periods, which implies a slow cash conversion cycle. It is calculated by adding the days inventory outstanding to the days sales outstanding and subtracting the days payable outstanding. Each of the mentioned metrics has got different implications on the conversion cycle. A lower DSO implies a shorter collection period, lower DIO is significant of a fast moving inventory and a lower DPO is significant of a longer payment period. DSO + DIO – DPO = CCC (cash conversion cycle) (Drake, and Fabozzi, 2010). Poor Working Capital Management leads to Corporate Failure There are a host of reasons affecting the working capital position of a business. Both excess and shortage of working capital has got negative implications of a poor cash management system that reduces the earnings of the business. Excess working capital usually means excess inventory balances of a company. Inventory is an idle asset, it results in opportunity cost of the firm i.e. the returns that could have been generated if it was employed in operations or sold in the open market (Chew, 2013). A negative working capital means that the firm has inadequate resources to meet its short term liquidity i.e. the firm’s short term solvency position is weak. Poor working capital management cannot only be attributed to the inefficient financial functions, but it also includes strategic reasons of the firm. Strategic functions of a firm include the qualitative judgements like growth, market size, acquisition or divestment, competitors, product development and innovation, technology up gradation, promotional activities and others. Moreover it includes the analysis of the external environment of the business vis-a-vis political, economic, social, technology, legal and environment. The strategic functions of a business are incumbent on the financial functions. Both the strategic and financial causes of poor working capital management are briefly discussed below (Ittner, and Larcker, 2003): Strategic reasons External environment – In ability to gauge market competition, competitors, government and other regulatory authority’s policies and reforms. Resource constraints – In adequate human and capital resource to meet its short term and long term goals. Customers – Unsatisfied customers, failure to understand buying behaviour, target market and others. Employees- lack of proper incentive structure, employee hygiene and reward system. Lack of employee commitment to business goals. Ineffective communication - lack of co-ordinated effort and reporting system. Stakeholder interest – Ensuring better returns and adding values to the stakeholder community i.e. suppliers, shareholders, customers, employees and others (Sadler, 2003). Financial Reasons Financial factors are the key indicators; they quantify the reasons for poor working capital position of a firm apart from the strategic reasons which are qualitative in nature. The financial factors include: Low sales generation – It leads to excess of current liabilities over assets, which results in shortage of working capital. It creates liquidity problems. Over utilization of human resource at primary level- companies should ensure adequate employment of human resources. Over employment of store personnel and inventory will unnecessarily lead to high wage payments, eroding the cash flows. Long customer payment cycle – This reduces the cash flows of a business. Longer collections cycle means that late payments from customers, will lead to less amount available for vendor payments. Past accounts receivables - High accounts receivables indicates that firm’s cash is locked in overdue bills, which creates constraints in meeting its debt obligation. Excess inventory – Over estimated inventory leads to high opportunity cost. A high inventory level which has low turnover increases the stock holding cost, thus adding to cash flow constraints. Inventory quality is also an important factor, as it is a key determinant of a firm’s quick position. Inventory cannot be easily converted into cash as it is dependent on the marketability, demand and other important market determinants. Low inventory turnover – It is significant of a slow moving inventory, which leads to lower revenue collection. It can be counter argued that such low turnover has a positive bearing on the ordering cost of the stock that increases the earning potential. Increased interest payment on short term working capital loan – Inadequate working capital results in firms taking overdrafts or working capital loans. Such sources of finance have interest charges that reduce the profit of the firm. Default in payment to suppliers also has interest charge implication, which further affects the working capital position. Longer cash conversion cycle – It shows management inefficiencies in converting its inventory to cash. Delay in the cash cycle indicates that the company takes long time to generate revenue, resulting in low interim cash flows that further necessitate the need of short term resources. Longer working capital cycle – If period for accounts payable is shorter than accounts receivables, it increases the working capital cycle. Collection period should precede the payment period; else it creates a need for short term finance to improve its liquidity. High cost of inventory – Financial managers should use appropriate valuation techniques, to estimate its inventory. It should reduce the cost of holding inventory so as to increase its earnings. Strategic and Financial reasons leading to Corporate Failure Default in payment to suppliers/creditors will lead to high interest payments and cost the business its credibility leading to high supplier bargaining power. Financial managers target high liquidity ratios like current and quick ratio to ensure a strong liquidity position that determines its solvency position in the short run. Current ratio signifies that with a given level of short term assets whether a company is able to meet its current liabilities, whereas quick ratio is significant of how quickly can a company convert its short term assets to cash to pay of its short term debt obligation. Inventory is usually not considered as a quick item as at times it is difficult to convert it to cash, owing to its low market demand or slow moving nature. The above factors can prove to be detrimental for the financial health of the company leading to bankruptcy. If a business fails to pay of its creditors with insufficient short term assets, it might engage in distress sale of its other assets to compensate for its short term liquidity. In doing so the company might declare bankruptcy (Cox and Fardon, 2008). On a strategic level, management decisions influence the level of working capital. Strategies implemented at various levels impacts the financial functions which lead to short term asset and liability mismatch (Henry, 2008). For example, if the management of company X decides to acquire another company Y and as a result of the acquisition the consolidated working capital of the firm X increases. Now firm X has idle inventory balances in its account which needs to be utilised to generate cash flows for the firm as a whole. The management of firm X has no plans to manage the excess working capital, as a result firm starts losing its potential to generate more cash flows following the acquisition. This limits higher levels of earning for the firm, resulting in lower after tax earnings and return to the stockholders which in turn would reduce the firm’s value. On the contrary there might be cases where a company should maintain high levels of working capital anticipating recessionary trends, inflation, labour problems, supply shortages, etc (Lasserre, 2012). Example - The Big US automobile manufacturers reduced its high working capital level of $830 million in four months time, owing to its inefficient strategic and financial decisions. It ignored the key working capital implications during supplier partnerships, had shorter payment cycles, lacked integrity in sharing information on the level of short term assets and had several supply bottlenecks. The supply shortages lead to longer cash conversion cycle resulting in excess working capital (REL, 2011a). WCM Components Strategic Components: • Market segment (Sagner, 2010) • Product • Price • Promotion • Place • Customers • Suppliers Financial Components: • Short term assets i.e. inventory, cash, debtors and marketable securities • Short term liabilities i.e. creditors, bank overdraft and cash credit and payables. • Working capital cycle • Cash conversion cycle (Pandey, 2009). Causes of poor WCM Strategic reasons: • Resource constraints • Changing tastes and preferences of customers • High supplier bargaining power • Employees unaware of strategic implication Financial reasons • High inventory value • Longer collection period • Shorter payment period • Ineffective inventory valuation techniques (Poor) WCM and Corporate Failure link Wrong strategic implementation leads to unsatisfied customers and drop in market share. This reduces the revenue and average collections, leading to liquidity problem. The financial metrics show the measure of the strategic actions. It affects the short term liquidity of companies, resulting in fire sale of assets. Examples of poor WCM: Cytec Recessionary trends lead to a fall in business activity in 2008 and difficult conditions in the market existed. Global Aerospace Corporation There was lack of proper reporting system of payment and collection terms as well as ineffective inventory valuation and pricing techniques. Cytec Cash flows reduced due to high working capital. Working capital was in excess by $200 million. Global Aerospace Corporation There was wrong practice of valuation techniques that showed higher inventory values, resulting in higher level of working capital. Effective Working Capital Practices It is imperative for any business concern to increase its cash generations. Business’ at times face acute cash shortages to meet its short term liabilities. Though the mismatch arises due to shortage or excess of current assets, still the liability side should be considered to improve the overall working capital position (Mathur, 2007). The effective ways to improve the working capital of a firm are as follows: Alternative sources of funding should be used than considering debt finance. Bank overdrafts and short term loans add to the interest burden of businesses. Firms should consider asset based financing like discounting bills, web based finance, etc. Managing inventory is another key factor that creates liquidity problems for businesses. Managers should consider various techniques like economic order quantity, reordering level, margin of safety, etc. They should consider inventory valuation techniques like FIFO and LIFO to better estimate the stock value. Excess inventory creates an increase in the working capital level that reduces the cash generation. Companies should also consider the reasons behind a slow moving inventory that makes it highly illiquid (Brigham and Houston, 2011). Accounts receivable and payable should be actively managed to improve the cash position. Companies should ensure a sound working capital cycle that compliments its strategic goals. Payments to vendors should not be made before the due date and collections period should be shortened. Should closely monitor credit checks on customers. Supplier payments should be made on time; else it might lead to interest penalty and disrupt the supply process totally. Default in payments will cost the company its market credibility and result in high prices for supply and high bargaining power for vendors. Companies should lay distinctive strategies at all levels for better functionality of its financial metrics. Strategies should have a 360 approach to its business operations; else a shortfall in either of them might lead to financial adversities, leading to corporate failure (Chorafas, 2002). Managing inventories: Inventory cannot be easily converted to cash owing to its market conditions. Keeping low levels will help reduce the holding cost (Merna, and Al-Thani, 2011). Managing cash: Cash itself is an idle asset; it should be employed in business operations to increase the cash flow. Managing trade receivables: Receivables should have shorter cycles. It will help pay off its current debts without resorting to external finance. Managing trade payables: Companies should ensure that payments to vendors are not made before the due date, as this might increase the working capital cycle, affecting its short term solvency position. Better payment options and discounts from suppliers. The Case of Cytec Industries Cytec is a US based chemical manufacturing company that has its business spread across 35 countries. It manufactures products for various market segments like inks, mining, automotive, adhesive, and aerospace. Key factors affecting Cytec’s working capital position With the economic downturn in 2008, Cytec’s business activity started to decline Cash flows were acute to the prevailing market conditions and moreover it had to refinance its long term debt by 2009 (Q3). Cytec’s witnessed a growth in its working capital in the successive years owing to its inorganic growth. It reported excess working capital to the extent of $200 million. It exhibited high level of stock pile that reduced its cash flow generation. Cytec planned to utilise its idle inventory in business activities to increase its cash flow position. Cytec’s working capital practices It took some effective measures to control the various metrics related to working capital. It setup an integrated system to reduce the collection cycle and report in the books any accounts receivables exceeding a year. It implemented an efficient inventory management system based on product category and cost. It also setup a control system that ensured no advance payment of accounts payable before the due date. It adjusted its collection and payment period to leverage its working capital position. It managed to reduce its DSO (day’s sales outstanding), DPO (day’s payable outstanding) and stock in hand, to effectively convert its short term assets to cash so as to strengthen its liquidity position. Following the control measures Cytec was able to reduce its working capital by 40% (REL, 2011c). The Case of Global Aerospace Corporation It is a US based company that provides technical support to civil, military and commercial markets to aid space missions. Key factors affecting Aerospace Corporation’s working capital position It failed to report its vendor report which included changes in payment terms of suppliers. It witnessed longer debt collection period and did not report such issue to the management, leading to unidentified reason and a bubble in high book value of working capital. The global purchasing team used historical cost technique to value its inventory which resulted in wrong estimation of the working capital level. The presence of such inefficiencies leads to high working capital level which had a negative impact on its cash flows. Aerospace Corporation’s Working Capital Practices The company revised its payment collection period by moderating payment terms and controlling payment of bills before due date. It also built an electronic system to reduce longer collection periods and resolve billing discrepancies. It initiated key performance indicators to monitor payables and receivables cycle. Following the practices Aerospace Corporation was able to reduce its working capital corpus by €67 million. It made payment policy reviews and successfully negotiated with more than 8000 suppliers. It also managed to resolve the issues relating to bills payable with a measure of 50%. The company after implementing the various control measures was able to generate more cash to meet its short term debts resulting in increased liquidity (REL, 2011b). Conclusion Liquidity problem is an inherent risk in a business. It should be strategically addressed to maintain adequate level of working capital. Though excess working capital removes the opportunity for a business to generate higher cash flows, still at times it is required to maintain such high levels of net current assets to meet market adversaries vis-a-vis recession, inflation, supply bottlenecks, supplier bargaining power, etc. It is the duty of financial mangers to ensure high solvency position so as to protect the company from being bankrupt. Efficient working capital practices would not only include the financial factors but also the strategic factors. If strategies are not well formulated, communicated, interpreted and initiated it will lead to corporate failure. Financial metrics are generally used as a metric for evaluating the strategic functions. References Alleman, A., 2012. Current Assets. USA: Xlibris Corporation. Brigham, E., and Houston, J., 2011. Fundamentals of Financial Management. Ohio: Cengage Learning. Chew, H., D., 2013. Corporate Risk Management. New York: Columbia University Press. Chorafas, N., D., 2002. Liabilities, Liquidity, and Cash Management: Balancing Financial Risks. New Jersey: John Wiley & Sons. Cox, D., and Fardon, M., 2008. Management of finance. Worchester: Osborne Books. Drake, P., P., and Fabozzi, J., F., 2010. The Basics of Finance: An Introduction to Financial Markets, Business Finance, and Portfolio Management. New Jersey: John Wiley & Sons. Henry, A., 2008. Understanding Strategic Management. New York: Oxford University Press. Ittner, C. D., and Larcker, D. F., 2003. Coming up short on nonfinancial performance measurement. Harvard Business Review, pp. 88-95. Lasserre, P., 2012. Global Strategic Management. Singapore: Palgrave Macmillan. Mathur, B., S., 2007. Working Capital Management And Control: Principles And Practice. New Delhi: New Age International. Matz, L., 2011. Liquidity Risk Measurement and Management. USA: Xlibris Corporation. Merna, T., and Al-Thani, F., F., 2011. Corporate Risk Management. West Sussex: John Wiley & Sons. Pandey, M., I., 2009. Financial Management. Noida: Vikas Publishing House Pvt Ltd. Periasamy., 2009. Financial Management. New Delhi: Tata McGraw-Hill Education. REL., 2011a. Automotive Manufacturer reduces its Working Capital by over $830 million in just 4 months. [Online] Available at: http://www.relconsultancy.com/solutions/casestudies/REL-Automobile-Manufactures-Case1.pdf. [Accessed on 17 March 2015]. REL., 2011b. Aerospace and Defense company reduces its working capital by €67 million. [online] Available at: http://www.relconsultancy.com/solutions/casestudies/REL-Aerospace-Defense-Case2.pdf. [Accessed on 17 March 2015]. REL., 2011c. Cytec Industries reduces working capital 40%. [Online] Available at: http://www.relconsultancy.com/solutions/casestudies/REL-Specialty-Chemicals-Case2.pdf. [Accessed on 17 March 2015] Sadler, P., 2003. Strategic Management. London: Kogan Page Publishers. Sagner, J., 2010. Essentials of Working Capital Management. New Jersey: John Wiley & Sons. Spurga, C., R., 2004. Balance Sheet Basics: Financial Management for Non-financial Managers. USA: Penguin Group. Read More