Case study

Marico - Working capital improvement may accelerate value creation; reiterate preferred pick status - ICICI Securities

While Indian FMCG's value-creation story over 2010-2020 has been primarily driven by good earnings growth, we note instances (Emami and GSK Consumer) where accelerated value-creation was driven by working capital (WC) improvement (and hence higher OCF / FCF). In this report, we highlight the Marico story - it improved WC by 30 days to 17 days in FY21 driven by (1) SKU rationalisation, (2) new manufacturing footprint and automated systems, (3) lower receivables and (4) stricter credit control in general trade. We believe this improvement is largely sustainable and model WC days of 24 days and 23 days in FY22e and FY23e. BUY; TP Rs550.

- Case studies of balance sheet driven value creation: Emami and GSK-Consumer (now acquired by HUL) are two FMCG companies where OCF / FCF improvement drove value creation in the past. During FY04-FY15, Emami's profit, and market cap CAGR were 33% and 46% with a big jump in FCF. Similarly, GSK's profit, FCF and market cap CAGR (over FY04-FY14) were 24%, 14% and 37%. See Figures 3-6. Furthermore, RoCE for both Emami and GSK improved to 44% and 50% from 7% and 15% during FY04-FY14. We note that GSK's working capital improvement is credited to new policies under the stewardship of the then CFO, Ramakrishnan Subramanian (Subu).

- Marico value creation to be driven by both balance sheet improvement and P&L: We highlight balance sheet improvement at Marico driven by management's focus on working capital efficiencies - inventory (reduced inventory days by 18 days to 51 days in FY21) focus driven by SKU rationalisation, new manufacturing footprint and automated systems, lower receivables (reduced receivables days by 9 days to 18 days in FY21) through order management system with zero manual intervention and stricter credit control in general trade. That said, some of the working capital reduction was driven by (1) lower share of modern trade and Canteen Stores Dept. (have higher receivables than general trade) and (2) lower raw material inventory (particularly copra) given the expectation of (some) input price correction.

- Leaner system to help drive NPD agenda. We believe a leaner distribution system (possibly improving distributor ROI as well) will give Marico the headroom to push its new products in GT. Some of the initial traction may be potentially seen in Healthy Foods (Honey, Chyawanprash and Soya Chunks). Marico has already ramped up (1) direct distribution in both rural and urban areas and (2) e-commerce share (8% contribution - amongst the highest in our coverage) to aid new product development and pre-miumisation.

- Marico has P&L drivers too - We model earnings growth of 12% and 21% in FY22e and FY23e driven by (1) continuing market share gains in Parachute coconut oil, (2) sustained recovery in value-added hair oils (VAHO) with all the brands likely to grow in double-digits, (3) continued growth momentum in Saffola edible oils (increased penetration), (4) new launches in healthy foods portfolio (entered larger categories like Honey, Chyawanprash, Noodles etc. - targeting Rs4.5-5bn revenue in FY22 and Rs8.5-10bn by FY24) and (5) international business likely the most resilient (versus Dabur and GCPL) with low exposure to the Middle East (12%).

- Valuation and risks: Our earnings estimates are unchanged; modelling revenue / EBITDA / PAT CAGR of 13 / 13 / 16 (%) over FY21-23E. Maintain BUY with DCF-based target price of Rs550 (Rs500 earlier). At our target price, the stock will trade at 45x P/E multiple Mar-23E. Key downside risk is higher-than-expected inflation in copra prices and demand deceleration.

Shares of MARICO LTD. Was last trading in BSE at Rs.475.1 as compared to the previous close of Rs. 470.95. The total number of shares traded during the day was 64076 in over 2098 trades.

The stock hit an intraday high of Rs. 479.95 and intraday low of 471.4. The net turnover during the day was Rs. 30459575.

3.1 Concept of working capital

The term Working Capital also called gross working capital refers to the firm‘s aggregate of current assets and current assets are these assets which can be convertible into cash within an accounting period, generally a year. Accounting Standards Board, The Institute of Chartered Accountants of India defines, “Working capital means the funds available for day-to-day operations of an enterprise. It also represents the excess of current assets over current liabilities including short-term loans.”

Working capital has two concepts:

i)    Gross working capital

Gross Working capital refers to the total of the current assets. Gross working capital is more helpful to the management in managing each individual current assets for day-to-day operations.

Ii) Net working capital

Net working capital refers to the excess of the current assets over current liabilities. In the long run, it is the net working capital that is useful for the purpose.

There are two types of working capital-

(a)    Rigid, fixed, regular or permanent working capital

Every business concern has to maintain certain minimum amount of current assets at all times to carry on its activities efficiently and effectively. It is indispensable for any business concern to keep some material as stocks, some in the shape of work-in-progress and some in the form of finished goods. Permanent Working Capital is the irreducible minimum amount of working capital necessary to carry on its activities without any interruptions. It is that minimum amount necessary to outlays its fixed assets effectively.

(b)    Variable, seasonal, temporary or flexible working capital

Temporary working capital is that amount of current assets which is not permanent and fluctuating from time to time depending upon the company‘s requirements and it is generally financed out of short term funds, It may also high due to seasonal character of the industry as such it is also called seasonal working capital.

Temporary working capital

Permanent working capital

Figure 1: Types of working capital

Nature of Working Capital

Working capital is works as breath of the company without which an organisation cannot survive. Some of the features of working capital are-

Ii. It changes form constantly to keep the wheels of business moving.

Iii. Working capital enhances liquidity, solvency, creditworthiness and reputation of the enterprise.

Iv. It generates the elements of cost namely: Materials, wages and expenses.

v. It enables the enterprise to avail the cash discount facilities offered by its   suppliers.

Planning of Working Capital

There are many factors that determine the size of working capital. Planning of working capital is depend on following factors-

A company‘s working capital requirements depends on the activities it carried on and its size too. For instance, public utility organisation or service organisation where its activities are of mere service nature, does not require high amount of working capital, as it has no need of maintaining any stocks of inventories. In case of trading organisation the magnitude of working capital is high as it requires to maintain certain stocks of goods as also some credit to debtors. Further, if we go to manufacturing organisation the cycle period of working capital is high because the funds are to be invested in each and every type of inventory forms of raw-material, work-in-progress, finished goods as also debtors. Industrial units too require a large amount of working capital.

2.  Production Policies:

These policies will have a great significance in determining the size of the working capital. Where production policies are designed in such a way that uniform production is carried on throughout the accounting period, such concern requires a uniform and lesser amount of working capital. On the other hand, the concerns with production policies according to the needs of the customers will be peak at sometimes and require high amount of working capital. In seasonal industries too, where production policies are laid down tightly in the business season requires a high amount of working capital.

3.  Process of Manufacture:

If the manufacturing process of a particular industry is longer due to its complex nature, more working capital is required to finance that process, because, longer the period of manufacture, the larger the inventory tied up in the process and naturally requires a high amount of working capital.

4.  Growth and Expansion of Business:

A business concern at status requires a uniform amount of working capital as against the concerns which are growing and expanding. It is the tendency of any business organisation to grow further and further till its saturation point, if any. Such growth may be within the existing units by increased activities. Similarly, business concerns will expand their organisation by establishing new units. In both the cases, the need for working capital requirement increases as the organisation increases.

5.  Fluctuations in the Trade Cycle:

Business activities vary according to the general fluctuations in the world. There are four stages in a trade cycle which affects the activities of any business concern. Accordingly, the requirements of working capital are bound to change. When conditions of boom prevail, it is the policy of any prudent management to build or pile up large stock of inventories of various forms to take the advantage of the lower prices. Such fluctuations cause a business concern to demand for more amount of working capital. The other phase of trade cycle i.e., depression i.e., low or absence of business activities cause business concerns to demand for more working capital. In condition of depression, the products produced are not sold due to fall in demand, lack of purchasing power of the people. As a result of which entire production obtained was not sold in the market and high inventories are piled up. Therefore, there arises the need for heavy amount of working capital.

6.  Terms and conditions of Purchases and Sales:

A business concern which allows more credit to its customers and buys its supplies for cash requires more amount of working capital. On the other hand, business concerns which do not allow more credit period to its customers and seek better credit facilities for their supplies naturally require lesser amount of working capital.

7.  Dividend Policy:

A consistent dividend policy may affect the size of working capital. When some amount of working capital is financed out of the internal generation of funds such affect will be there. The relationship between dividend policy and working, capital is well established and very few companies declare dividend without giving due consideration to its effects on cash and their needs for cash. If the dividend is to be declared in cash, such outflow reduces working capital and therefore, most of the business concerns declare dividend now-a-days in the form of bonus shares as such retain their cash. A shortage of working capital acts as powerful reason for reducing or skipping cash dividend.

8.  Price Level Changes:

The changes in prices make the functions of a finance manager difficult. The anticipations of future price level changes are necessary to avoid their affects on working capital of the firm. Generally, rising price level will require a company to demand for more amount of working capital, because the same level of current assets requires higher amount of working capital due to increased prices.

9.  Operating Efficiency:

The Operating efficiency of a firm relates to its optimum utilisation of resources available whether in any form of factor of production, say, capital, labour, material, machines etc. If a company is able to effectively operate its costs, its operating cycle is accelerated and requires relatively lessor amount of working capital. On the other hand, if a firm is not able to utilise its resources properly will have slow operating cycle and naturally requires higher amount of working capital.

10.   Percentage of Profits and Appropriation out of Profits:

The capacity of all the firms will not be same in generating their profits. It is natural that some firms enjoy a dominant and monopoly positions due to the quality of its products, reputations, goodwill etc. (for example Colgate Tooth Paste, Bata Chapels etc.,)and some companies will not have such position due to poor quality and other inherent hazards. The company policy of retaining or distribution of profits will also affect the working capital. More appropriation out of profits than distribution of profit necessarily reduces the requirements of working capital.

11. Other Factors:

Apart from the above general considerations, there may be some factors responsible for determination of working capital which are inherent to the type of business. Some of such factors may be as follows:

(a) General co-ordination and control of the activities in the organisation.

(b) Absence of specialisation of products and their advantages.

(c) Market facilities.

(d) Means of transport and communication system.

(e) Sector in which the firm works i.e., private or public sector etc.

(f) Government policy as regard to: i) Imports and Exports

(g) Tax considerations.

Key takeaway-

3.2 Estimation / Projection of Working Capital Requirement in case of Trading and Manufacturing Organization

Two components of capital are current assets and current liabilities. Estimation   of the amount of current and current liabilities to maintain a certain level of operation is not an easy task. The lack of working capital disrupts the smooth production process, and excess working capital increases costs. Here we describe the estimation of working capital in case of trading and manufacturing concerns.

The following procedure should be employed to estimate working capital for manufacturing concerns:

(a) Expected production per week or per month.

(b) Determination of costs for each element, namely material, labour and overhead, as well as profit per unit;

(c) Calculation of the amount blocked for each week/month for each element of cost and profit;

(d) Determination of the operating cycle by estimating the raw material retention period. Processing time, storage period of finished products, debt collection period. The period of payment of creditor it takes time lag in pay and overhead payments.

(e) Determining the net block period. This is the period during which each element of the cost remains blocked. For example, if the raw material remains in the store for 2 weeks after purchase, the processing time is 2 weeks, the finished product remains in stock, 3 weeks if the credit period extended to the debtor is extended for 4 weeks, and the payment for the material is made for 2 weeks after purchase, the net block period is as follows:[(2+ 2 + 3 + 4) – (2)] = 9 a few weeks.

(f) Obtain the working capital requirements for each element of the cost by multiplying the net block period calculated in step (e) and the amount blocked for each element of the cost according to step (c).

(g) Get the total amount of working capital, if any, by summing up the costs and all the amounts calculated for each element of the desired cash.

Key takeaways-

3.3 Operating Cycle

The operating cycle (OC) refers to the amount of days a business must receive inventory, sell inventory, and collect cash from the sale of inventory. This cycle of role decisions is more efficient. The operating cycle is expression is:

Operating cycle=inventory period + accounts receivable period

Where,

The inventory period = the time that the inventory is kept until it's sold.

The assets period = the time it takes to recover cash from the sale of inventory.

The inventory period is calculated as follows:

Inventory Period=365/inventory turnover

The formula for inventory turnover is:

Inventory turnover=cost of products sold/average inventory

The assets period is calculated as follows:

Accounts receivable Period= 365 / assets sales

The formula for calculating the turnover of assets is as follows:

Accounts receivable sales = average assets sales of credit assets average assets    sales of credit assets

So the detailed expression for operating cycle is:

Operating cycle=365/(cost of goods sold ⁄average inventory)+365/(credit sale ⁄average accountable receivable)

The following could be the reasons for longer operating cycle period:

(a) Purchase of materials in excess/short of requirements.

(b) Buying inferior, defective materials.

(c) Failure to get trade discount, cash discount.

(d) Inability to purchase during seasons.

(e) Defective inventory policy.

(f) Use of protracted manufacturing cycle.

(g) Lack of production planning, coordination and control.

(h) Mismatch between production policy and demand.

(i) Use of outdated machinery, technology,

(j) Poor maintenance and upkeep of plant, equipment and infrastructure facilities,

(k) Defective credit policy and slack collection policy.

(l) Inability to get credit from suppliers, employees,

(m) Lack of proper monitoring of external environment etc.

Remedies to reduce the operating cycle

The purchase manager owes a responsibility in ensuring availability of right type of materials in right quantity of right quality at right price on right time and at right place. These six R’s contribute greatly in the improvement of length of operating cycle. Further, streamlining of credit from supplier and inventory policy also help the management.

Ii. Production Management:

The Production manager affects the length of operating cycle by managing and controlling manufacturing cycle, which is a part of operating cycle and influences directly. Longer the manufacturing cycle, longer will be the operating cycle and higher will be the firm’s working capital requirements.

The following measures may be taken like:

(a) Proper maintenance of plant, machinery and other infrastructure facilities,

(b) Proper planning and coordination at all levels of activity,

(c) Up-gradation of manufacturing system, technology, and

(d) Selection of the shortest manufacturing cycle out of various alternatives etc.

Iii. Marketing Management:

The sale and production policies should be synchronized as far as possible. Lack of matching increases the operating cycle period. Production of qualitative products at lower costs enhances sales of the firm and reduces finished goods storage period. Effective advertisement, sales promotion activities, efficient salesmanship, use of appropriate distribu­tion channel etc., reduce the storage period of the finished products.

Iv. Credit Collection Policies:

Sound credit and collection policies enable the Finance manager in minimizing investment in working capital in the form of book debts. The firm should be discretionary in granting credit terms to its customers. In order to see that the receivable conversion period is not increased, the firm should follow a rationalized credit policy based on the credit standing of customers and other relevant facts. The firm should be prompt in making collections. Slack collection policies will tie-up funds for long period, increasing length of operating cycle.

v. External Environment:

The length of operating cycle is equally influenced by external environment. Abrupt changes in basic conditions would affect the length of operating cycle. Fluctuations in demand, competitors, production and sales policies, government fiscal and monetary policies, changes on import and export front, price fluctuations, etc., should be evaluated carefully by the management to minimize their adverse impact on the length of operating cycle.

Vi. Personnel Management:

The Personnel manager by framing sound recruitment, selection, training, placement, promotion, transfer, wages, incentives and appraisal policies can contrast the length of operating cycle.

Key takeaways-

Practical problems

Q.1. Sanket Ltd. Had an annual sale of 50,000 units, at Rs. 100 per unit. The company works for 50 weeks in the year.

The cost details of the company are as follows

The company has to practice of storing raw materials for 4 week's requirements. Wages and other expenses are paid after a lag of 2 weeks. Further the debtors enjoy a credit of 10 weeks and company gets a credit of 4 weeks from the suppliers. The processing time is 2 weeks and finished goods inventory is maintained for 4 weeks. From the above information prepare a working capital estimates, allowing for a 15% contingency.

Solution:

Statement showing Estimation of Working Capital

Working Notes:

Q.2. The Board of Directors of Century Rayon Ltd. Requests you to prepare a statement showing requirements of working capital for a forecast level of activity of 52,000 units in the ensuring year (52 weeks) from the following information made available.

a)   Selling price - Rs. 100/- per unit.

b)  Raw material in stock - average 4 weeks.

c)   Work-in-progress - average 4 weeks.

d)  Finished goods in stock - average 4 weeks.

e)   Credit allowed to debtors - average 8 weeks.

f)     Credit allowed by supplier - average 4 weeks.

g)  Cash at bank is expected to be Rs.50,000.

h)   All sales are a credit basis.

i) All the activities are evenly spread out during the year.

j) Debtors are to be valued at sales.

Solution:

Statement showing Estimation of Working Capital

Working Notes:

2.   Units= 52,000/52 weeks = 1000 units per week.

Q.3. From the following data, prepare a statement showing working capital requirement for the year 2009:

a) Estimated activity for the year 45,000 units (12 months).

b) Stock of raw material 2 months and material in progress 2 months, 50% of wages and overheads are incurred.

c) Finished goods 3 months storage.

d) Creditors 2 months.

e) Debtors 4 months.

f) Outstanding wages and overheads 2 months each.

g) Selling price per unit Rs.30.

h) Cost analysis per unit is as follows.

I. Raw materials 1/3 of sales.

II. Labour and overheads in the ratio of 3:2 per unit.

III. Profit per unit is Rs.10

i) Cash balance Rs.50,000

Assume that operations are evenly spread throughout the year.

Solution:

Statement showing Estimation of Working Capital

Working Notes:

For understanding: After deducting profit we get total cost per unit Rs.20.

Total cost Rs.20 includes Rs.10 cost of raw materials.

Balance Rs.10 per unit will be divided in the ratio of 3:2 i.e. Rs.6 labour and Rs.4 overheads.

Units= 45,000/12 months = 3,750 per month.

Q.4. Amit Ltd. Had an annual sale of 50,000 units, at Rs. 100 per unit. The company works for 50 weeks in the year.

The cost details of the company are as follows:

The company has to practice of storing raw materials for 4 week's requirements. Wages and other expenses are paid after a lag of 2 weeks. Further the debtors enjoy a credit of 10 weeks and company gets a credit of 4 weeks from the suppliers. The processing time is 2 weeks and finished goods inventory is maintained for 4 weeks. From the above information prepare a working capital estimates, allowing for a 20% Margin of Safety on gross working capital.

Solution:

Statement showing Estimation of Working Capital

Working Notes:

Q.5. From the following data, prepare a statement showing working capital requirement for the year 2009:

a)   Estimated activity for the year 45,000 units (12 months).

b)  Stock of raw material 2 months and material in progress 2 months, 50% of wages and overheads are incurred.

c)   Finished goods 3 months storage.

d)  Creditors 2 months.

e)   Debtors 4 months.

f)     Outstanding wages and overheads 2 months each.

g)  Selling price per unit Rs.30.

h)   Cost analysis per unit is as follows.

i)     Cash balance Rs.50,000

j)     Margin of Safety @ 20% on Net working capital

Assume that operations are evenly spread throughout the year.

Solution:

Statement showing Estimation of Working Capital

Working Notes:

For understanding: After deducting profit we get total cost per unit Rs.20.

Total cost Rs.20 includes Rs.10 cost of raw materials.

Balance Rs.10 per unit will be divided in the ratio of 3:2 i.e. Rs.6 labour and Rs.4 overheads.

Margin of Safety is calculated as follows= 7,62,500/80 x 20 = 1,90,625 (reverse calculation)

References-

1. Cost and Management Accounting - Colinn Dury 7th Edition

2. Cost and Management Accounting- Dbarshi Bhattacharyya pearson Publications 2013 edition

3. Management Accounting - M.Y.Khan

4. Management Accounting - I.M.pandey.

5. Www.icai.in