Working Capital Management - Essay Example

? Working Capital Management Working Capital Management The aim of this paper is to show what working capital management is in the context of a financial institution. The paper will also demonstrate how management of an organization can control the working capital so as to maximize profitability. The paper will look at the different advantages that are accrued by financial institutions in relation to their account receivables and their loan lending capacities. It will look at the financial growth and maturity of Citibank Indonesia, and the various strategies incorporated to deal with sovereign risk limits. It will draw its analysis and discussion from the combination of the account receivables and how they affect profitability either negatively or positively. The paper will conclude by highlighting the importance of managing working capital in each and every organization. This is with the financial thought line that without this type of management, any business is bound to run into great losses or ultimately its demise. Table of Contents 1.0 Abstract……………………………………………………………………………….......2 2.0 Introduction…………………………………………………...………………………….4 3.0 Methodology…………………………………………………………………...…………6 4.0 Analysis………………………………………………………………………………...…6 4.1 The 1983 risk return ratio…………………………………………………………6 4.2 Staff turnover……………………………………………………………………..6 4.3 Sovereign risk limit……………………………………………………………......7 4.4 Effect of Indonesia’s GDP on Citibank’s profits………………………………….8 4.5 Explanatory variables……………………………………………………………...9 4.6 Analysis of working capital……………………..……………………………….10 4.7 Working capital financing………………………………………………………..10 4.8 Line of credit…………………………….……………………………………….11 4.9 Account receivable financing……………………………..……………………..11 4.10 Factoring…………………………………………………………………12 4.11 Inventory financing………………...…………………………………….13 4.12 Term loans…………….…………………………………………………14 5.0 Discussion………………...……………………………………………………………...15 6.0 Conclusion……...………………………………………………………………………..17 7.0 References……….………………………………………………………………………19 Introduction Working capital for any firm is defined as the amount of money or current assets required by an organization for its everyday running. Liquidity in a business ensures that it remains solvent and that all its operations can be successfully undertaken. Cash, therefore, is a crucial part of the survival of any business organization. For this reason, sound financial management policies are paramount to the success of any business. Working capital management also involves providing finances for investment in the short term assets that are essential for the day to day running of the organization. They include reserve for unexpected costs, pre paid costs like operating licenses and insurance policies. Cyclic or seasonal financial needs should also be met. A clear example is the excessive spending of credit card holders during festive seasons like Christmas, where the banks experience an increase in lending. Good financial management will ensure that the banks can give as much money as possible. There is also a delicate balance between too much solvency and profit maximization of an institution. Citibank, the principal operating subsidiary of Citicorp are among the biggest financial institutions in the world. Citibank has many international branches especially in south East Asia. In 1983, Citibank’s country manager for Indonesia, Melhi Mistri, was faced with the task of increasing profitability while managing the banks operating capital in line with reviews of its operating budget. He also had the momentous task of maintaining Citibank Indonesia as the biggest international bank in the country in terms of government financing and local lending. Nature and Significance of Working Capital Working capital is viewed as a liquid asset that does not last for more than a year in the firm. Its importance cannot be understated, just as fuel is necessary to the running of a car engine. The continuous circulation of money in any business is fundamental to its survival. There is, therefore, great importance in ensuring that there are maximum returns on any investment made using the working capital of a business. These returns must also to be in line with a strict timeline. This reduces the time working capital is held up. Starvation of working capital is a leading source of business failure. Management of working capital Traditionally, the success of many businesses has been attributed to factors like operations management, marketing and production factors. It has, however, been seen that the well being of these businesses is as a result of sound operating capital management (Kenneth, 2007). Since working capital forms a larger chunk of monetary investment in a business, it is, therefore, easy to see why many business failures can be attributed to it. A business may also seem to be profitable, but if the profits do not originate from operations within an operating cycle, the business may result to borrowing to finance its working capital. Citibank in Indonesia This paper investigates the effects of working capital management in Citibank’s Indonesian subsidiary. It focuses on Melhi Mistri’s efforts on maximizing profits at a time when the Indonesian economy was going down. Methodology This study used online research methodology where analyses of all the financial statements of Citibank Indonesia in the 1983 financial year were scrutinized. Literature on working capital management theories and practices were also consulted for purposes of this analysis and discussion. This acted as primary and secondary sources of information for this study. Analysis According to the Indonesian’s president Suharto, the role of Citibank and other international banks that had been allowed into the country to assist with transferring capital into the country and establishing a modern banking infrastructure. Citibank was involved in operating in Indonesia because it wanted to serve its local and international customers, and also to share in the potential profits and growth that the Indonesian economy offered. The country was the fifth most populous country at the time in the world, and the economy was doing well prior to 1983. The 1983 Risk Return Ratio In 1983, Mr. Melhi was concerned with the risk to return ratio on operating capital. The Indonesian economy was greatly reliant on oil, and the prices had gone down. The economy had entered a slight recession, and Mr. Melhi had concerns on whether the government was going to take drastic measures to correct its balance of payment problems (Kenneth, 2007). Staff Turnover Citibank faced an increasing problem of high staff turnover. This was due to the fact that Citibank trained its own staff in what was considered Indonesia’s top bankers training program (Kenneth, 2007). For this reason, Citibank’s employees were lured into higher paying jobs by other banks. It was impossible for Citibank to compete with the salaries that were being paid by other banks. This was because the bank had a greater desire for higher profitability and lowered operating costs coupled with the fact that the bank had a limited branch network. This was as a result of limitation on foreign banks placed by the government in the country. Sovereign Risk Limits A sovereign risk refers to the concerns that a bank may be unable to recoup all its invested capital in a foreign country. They include macroeconomic risks and foreign currency exchange control put in place by the host governments that would make it difficult for clients to repay their dues or even expropriation of the bank’s assets (Kenneth, 2007). Each financial year, the bank set its sovereign risk limits for all overseas branches based on host country’s risk projections. In the light of the prevailing challenges, from loss of personnel to uncertainties in the economy, Mr. Melhi decided to operate with a self imposed sovereign risk limit, lower than the one approved in New York by Citibank’s management. He knew his sole responsibility was to manage the operating capital as well as risk. In late 1983, the budget for the whole bank was subjected to review and failed to hit the management’s desired numbers. Citicorp consolidated Institutional banks Individual banks Capital market groups revenue $5,883 $2,896 $2,380 $ 587 Net income $ 860 $758 $202 $128 Return on shareholder’s equity 16.5% 22.0% 17.7% 32.2% Return on assets .64% .87% .69% 1.29% Selected Citigroup financial records- 1983 (dollars in millions). Citibank Indonesia was categorized as an institutional bank. They had been given an after tax profit increase of between $500,000 and $1,000,000 (Kenneth, 2007). Mr. Melhi put his best effort to make sure that these goals were achieved while keeping watch on the operating capital movement. Effect of Indonesia’s GDP on Citibank’s profits Due to the slowing down of Indonesia’s economy in 1983, Citibank was considering a review of its lending policies. The bank was a major lender to the government for its infrastructure projects. It also considered reviewing the lending to private enterprise and the prime government. This was a way to reduce low return capital investments. However, Citibank was the largest international bank in Indonesia and such measures would not be in their best interest if the bank was still going to operate in the country (Kenneth, 2007). Failure to participate in these loans would have significant effects on the relationship between the government and also the prime customers. The only other option was to increase lending to large enterprises, but this was acceptable with emphasis to Indonesia’s prevailing economic situation. This was a dilemma for Mr. Melhi because adopting either of the two options would lead to risk exposure to both the financial and political arena. An increase in the operating budget was proposed by the Citigroup in New York. This did not in any way make the operating environment any different for Mr. Melhi. This shows that financial management is perhaps the most important tool when dealing with issues of operating capital management. Investing the available, operating capital would have meant, long repayment periods exceeding the acceptable capital cycle period. For these reasons, strict managerial inputs were necessary to salvage the situation. The desire by Citigroup to maximize profits was not in line with Citibank Indonesia’s need to carefully manage its working capital and the long term survival strategy. Explanatory Variables Cash inventory cycles is one way used to measure profitability because it shows the time lag between capital expenditure and the returns after sales or in the example of a bank, loan repayment. If the cycle takes a long time, the longer working capital will be held up. it is a huge sign of profitability when assets are returned into the operating cost in one form or the other. It relates the businesses asset base to its profitability. Several ways can be used to manage the gains from assets although the main aim is to increase profit and reduce the asset. Control Variables When accounting for the size of a business, and the many variables that may influence its profit several factors are considered. They include gearing ratio, (financial debts divided by total assets) and the gross working capital turn over (total sales/current assets) and also the ratio of current assets to total assets are always included as variables in the regression. Analysis of the Working Capital Gross working capital comprises of stock, debtors bank and cash balances. Working capital composition is dependent on a number of factors, which include operating level, operational efficiency level, policies on inventory, books debt policy, and the various technologies in use and also the nature of the industry. There is a great difference in the operations and types of the various industries, the degree to which businesses in the same industry are always expected to be recorded. This basically implies that the businesses in the same line, like Citibank and Barclays bank have similarities in the way working capital management affects their operations. Working Capital Financing There are various forms of working capital financing that a firm can use to finance its running costs. Each selected method has various advantages and the business should pick the financing option that best suits its needs. The analysis of the working capital financing helps in the structuring of suitable debt tools. There are five major working capital financing schemes. Line of Credit This is an open ended loan with a limit on the amount that can be borrowed by an organization. The business can repay the money at any time during the duration of the period of the line of credit. The business can also borrow at any time during the period of the line of credit. The interest is charged only on the borrowed amount. There are two types of line of credit loans, secured, where the business provides security or collateral for the loan and unsecured where no collateral is required. The security may be inventory or account receivable. The standard line of credit term is normally one year, and it is the private choice of the lender on whether or not to renew the loan. The loan account has to be fully paid within the year, and this is typically referred to as annual clean up. Line of credit finances insist on cyclical working capital requirements and not long term borrowing. To maintain a line of credit, a business must manage an operational account with the financial institution with a given percentage of money to be loaned out. For example, if the bank needs a 10% balance on the account, a $100,000 loan would actually be $90,000 to the business receiving the loan. Account Receivable Financing Some businesses lack the credit worthiness to allow them to take unsecured loans from financial institutions. Such firms can then use their account receivables as collateral for loan acquisition. The lenders rely on the business debtors to pay the principal amount. For this reason, the loan is a percentage of the account receivable and is highly reliant on the credit worthiness of the account receivable debtors. Businesses with strong debtors get up to 80% of account receivable as loan. Having debtors with a poor repayment record means the firm can only get up to 60% of account receivable. Customer repayments reduce the principal on the loan. Some account receivable financing requires the debtors to pay directly to them. In the case where the holder of the account receivable is unable to service the loan, the financing organization directly contacts the customers for payment. The fact that the loan is on account receivable allows the business to grow as a result of sales volumes. The business is also able to meet the challenges of funding the growth in sales. It allows firms to use the credit worthiness of its customers as a way of acquiring finances and hence achieving its growth. One disadvantage of this mode of lending to small firms is when the small firms try to deal with their account receivable percentages. Their businesses have to leverage all their accounts receivable since they cannot be used as collateral elsewhere. This is a problem to small firms whose account receivable is their major asset. Lenders may also opt to charge high interest rates due to the costs involved in managing the collateral. Factoring Factoring is the sale of account receivables by concentrating on third parties who incur the expense of debt collection and the risks involved. This third party is called the factor, and he assumes the risks associated with nonpayment but for a fee. The firm and the factor have to work out a payment period and credit limit for each customer. The factor then collects the money from customers and gives it to the organization, with the retention of discount to cover the operating expenses. The amount charged by the factor for collection of debts depends directly on the credit worthiness of the firms customers. The factor can advance up to 80% of payments by debtors to the firm before the actual receipt of the money. This provides businesses with cash flow before the sales are paid up. The disadvantages associated with this type of financing are the fact that the collection of debts may not be in line with the companies policies. This may affect the relationship between the clients and the firm. Some advantages of this type of financing include, the factor can collect the debts more easily and cost effectively as compared to the business because of economies of scale. It also provides businesses with a more reliable source of money from sales and services offered. The factor may, however, charge a higher fee than other loans if the customers have poor credit records. Factoring can be seen as a good alternative for firms that have a large customer base since it greatly reduces the operating expense. It also allows such firms to concentrate on other lines of business. Inventory Financing This is a secured loan where inventory serves as the main collateral in the acquisition of loans. Inventory as a form of collateral is much riskier than account receivables. This is because some types of inventory looses value quickly and hence cannot be held up for a long period of time like accounting receivables. Work in progress or partially processed goods have no resale value, and hence, firms with a great proportion of its working capital as work in progress cannot acquire reasonable financing from their inventory. Firms with standardized products such as motor vehicles and electronic equipment get better financing for their inventory. This is due to the market readiness of the stock and the non- perishability factor. Loans for these items may, however, be lower than those of account receivables (Pike & Pass, 1987). This is mainly because these items may have a short shelf life due to quickly evolving markets. For firms that inventory forms a large part of current asset base, inventory financing is very vital to fund working capital. Inventory pledged as collateral is not sold until the loan has been settled. There are two ways of ensuring that collateral is maintained until the loan account is settled. One way is by warehousing where goods are stored in a public warehouse and the lender maintains the storage receipt until payment is done. The second way is serialization of the inventory items where the lender can keep track of all the collateral items. They can only be sold when the account is fully or partially settled. Term Loans In contrast to the other forms of financing, term loans address medium term non cyclic working capital requirements. This means that the loan is long term and has a repayment period of between five and seven years (Anand, 2001). The lenders do not assume risks involved with interest rates and thus all loans attract a floating interest depending on the borrower’s risk level. These types of loans have fixed payment schedules. There are three different classifications, and they affect the bank and the business that it conducts on several levels. The first level principal insists on payment over the loan term where interest is charged on the remaining amount of loan. Level loan repayment is another scheme where the amount payable each month is the same but the ratio between principal and interest is not fixed. This means that, during periods of high interest rates, only a small amount goes to offset the principal and hence the repayment period may increase substantially. Partially amortizing loans repayment method is another way in which term loans are repaid. The firm has to pay a ballooned payment at the maturity of the loan. Term loans can either be secured or unsecured depending on the firm’s credit reputation. Since these are long term loans, there are covenants between lenders and the unsecured borrower. This ensures that the lender does not incur loses incase the firm deteriorates over the period of the loan. The borrower is expected to maintain a compensation balance between 10% and 20% of the loan. In case of a spike in interest, the repayment period increases. These types of loans put small firms under strain due to strict covenants and collateral requirement over an extended period of time. Discussion The Relationship between Accounts Receivable and Profitability From the earlier case study, it can be seen that there is a close relationship between the profits of the bank and the account receivables. In this case, the account receivables are loans that Citibank issues to the government and other prime lenders. A long period of repayment correlates to low profits. As seen in the case study, Mr. Melhi is conservative about increasing the amount of money to be loaned out. This is as a result of evaluation of the immediate future of the borrowers keeping in mind the prevailing economic times in Indonesia at the time (Kenneth, 2007). Another way that profit can be maximized is by reduction of the credit period of account receivables. From a borrower’s perspective, especially if the borrower is a small business trying to finance its working capital, this may be a big hurdle. Most of Citibank’s borrowers in Indonesia were small and medium scale businesses. They would have been unable to finance the loans advanced to them had Citibank adopted such a policy. The average number of days that cyclic working capital was held had a significant effect on the profitability of Citibank. This can be attributed to Citibank’s administration in New York, since they placed sovereign risk limits at a time when the Indonesian currency was not performing very well due to a drop in oil revenues. Mr. Melhi countered this by lowering the sovereign limit so as to allow a more flexible lending atmosphere. This illustrates a key role that management plays in deployment of working capital and its effect on the overall performance of a firm. The size of a firm plays a major part in the firm’s ability to generate profit and manage its working capital. Citibank is a large bank, but it lacked greatly in branch networking structures across Indonesia. This was as a result of government legislation limiting the operations of international banks in parts of Indonesia. This meant that local banks held a larger share of the banking market. It made it hard for Citibank to compete with the salaries being offered to employees. It was a major contributing factor to the high staff turnover. Operational profitability is also one of the factors that determine how managers manage not only working capital but also accounts receivables. If the profitability is high, more of the firm’s cyclic working capital is invested in accounts receivable. In the years prior to 1983, Citibank had experienced periods of high growth since the economy of the country was on an upward trend. Citigroup managers in New York had always expected growth in profits and hence their high operating capital and forecasted profits for 1983. The only way that Mr. Melhi could achieve the high profit targets set by Citigroup would be by lowering account receivables. This means that there would have been a substantial reduction in lending both to private enterprise and to the government. This would have played the part of lowering low interest loans that take longer to repay in favor of smaller loans with quick repayment periods. This can be seen as one way of lowering the operating budget expenditure on return investments. However, the long term prosperity of Citibank in Indonesia is a factor of good relations with the government and hence Mr. Melhi’s decision not to stop these loans. Conclusion There are various analytical techniques that have been used to identify some critical management practices employed by Citigroup’s country manager in Indonesia. The careful consideration of the various techniques has helped in the identification of areas that might need improvement in the firm. The case study can be applied to other firms in the banking sector, facing such challenges. This document provides managers and owners of various businesses with an insight of what capital management means. It also directs managers on ways that their peers have used to maintain profitability in light of difficult economic times. The techniques described above can greatly enhance financial operation of both large and small firms. A great understanding of operating capital financing is also discussed in great detail. The advantage of each scheme has been discussed, and their suitability for various types of businesses emphasized. Working capital for any business changes rapidly with time. There is an urgent need for institutions to cater for changing times in their operational manifesto, re-organizing their portfolio and managing their operating costs. Small firms and enterprises should learn the importance of operating capital management in relation to their operations. Capital starvation is one of the reasons why small businesses fail very rapidly. This is why operating capital financing has been discussed in this paper. Many of the financing options may not suit any type of business and hence the need for careful analysis before committing to a loan plan. The most important part of running a business successfully is having sound financial management ability. This has been seen throughout the paper as the best way to manage operating capital. References Anand, M. (2001). Working Capital Performance: An Empirical survey. New Delhi: Prentice Hall. Bhattacharya, H. (2001). Working Capital Management: Strategies and Techniques. Delhi: Prentice Hall. Chittenden, F. & Michael, N. (1998). Financial Management: Working Capital Practice. London: McGraw Hill. Kenneth, A. (2007). Management Control Systems: Performance Measure and Evaluation. London: Prentice Hall. Pike, H & Pass, C. (1987). Management of Working Capital: Management Decision. London: Free Press. Storey, D. (1994). Business Management: Understanding Small Businesses. London: Prentice Hall. Read More