Working capital: Unlocking excess cash

Why was 2013 a significant year? Indias economic growth rate fell to 5% in FY2013 the lowest figure in a
decade. While this slowdown can be partly explained by the weakness in the global economic environment,
it can also be attributed to a number of internal factors such as the lack of policy reforms, high inflation, and
volatile commodity prices and exchange rates.

Top challenges facing CFOs

A review of the performance of the leading 500 companies in the country reveals that sales growth has
halved, operating margins of the majority of the companies have declined and debt levels continue to rise.
ROCE was at a five year low of 11% against average cost of capital of 15%. Some of the key challenges
facing the CFOS are:

1. Decline in sales growth and EBITDA margins

A review of the sales performance of the leading 500 companies in India during FY2013 reveals that sales
growth halved during the year and EBITDA margin declined by 0.8% compared to the previous year.

A deep look at the results also indicates that 60% of the companies reported a decline in their operating
margins over the period under review.

Chart 1: Overall trend of sales and percentage of EBITDA/sales, 20092013

Source: EY analysis, based on publicly available annual financial statements

2. Volatile exchange rates and commodity prices

For Indian businesses, volatility in the prices of commodities and the weakness of the rupee against major
world currencies has adversely affected business planning. The Indian rupee depreciated by 13% (against
the US dollar) in the first half of FY2013 and closed at 7% lower on March 2013 than in March 2012. In the
first six months of FY2014, the Indian rupee sank further against the US dollar amid growing concerns about
the state of Indias economy and fears that the US will scale back its stimulus measures.
Chart 2: Change in rupee-dollar exchange rate

Source: RBI, exchange rate

3. Expensive and scarce capital availability

In March 2013, gross NPAs in the banking system grew by 16.5% to Rs 1.84 trillion and formed 3.42% of the
industrys advances. It has been growing progressively every year barring fiscal year 2011. The situation is
even bad when we look at the numbers along with restructured assets, the total loans subject to restructuring
amounts to Rs 2.41 trillion and total corporate debt restructuring amounts to 1.01 trillion in March 2013.
Public sector banks, which account for 76% of total loans of the industry, have major pie of these stressed
assets. On the backdrop of tightening of finance ministry and the RBIs directions, Banks are making strict
norms with respect to loans offered and collateral requirements to avoid past mistakes.
Chart 3: Gross and percentage share NPA for banks, 20092013

Source: RBI publication, Table 7.1: Bank Group-wise classification of Loan Assets of SCBs-2008 to 2013, EY Analysis

4. High debt levels and fall in ROCE

The top 500 companies in India have a total debt of INR19 trillion, which went up sharply in 2013 as
compared to 2009. Part of this debt was foreign denominated, putting additional strain on the countrys
balance sheet as the rupee continued to depreciate.

All of the above translated into a further fall in the return on capital employed (ROCE) of these businesses to
10.8% in 2013 from a high of 12.5% in 20102011. Consequently, Indian companies have been scrutinizing
their balance sheets and actively seeking ways to increase their cost efficiency, release cash and optimize
their asset structures.

Chart 4: Change in total debt, 20092013 Chart 5: Change in ROCE percentage, 20092013

Source: EY analysis, based on publicly available annual financial statements

Source: EY analysis, based on publicly available annual financial statements
Return on Capital Employed (ROCE) emerging as top priority

With the currency and commodity markets remaining volatile, regulatory environment being uncertain and
the general overall stressed economic environment, managing business has become extremely challenging.
The focus of many business is moving away from purely sales (or market share) growth or profitability (PAT,
EBIT or EBITDA) on to the more comprehensive returns metrics such as Return on Capital Employed
(ROCE) or Return on Equity (ROE).

Study of top Indian companies with high return on capital employed (ROCE) shows that many of these
companies have operated on negative working capital management. These companies are known to give
good returns to their shareholders, both in terms of dividends and capital gains. Ofcourse, some of the
sectors like retail and Telecoms have lower capital requirements than other sector such as cement or
pharmaceutical. However, our experience shows that a number of operational efficiencies and best practices
can be transported and implemented both within and across sector.

Chart 6: ROCE driver tree, EY Analysis

Negative working capital is one important parameter that no successful investor has ever missed.

Cash and working capital management is an especially interesting area it represents the cheapest form of
finance and a valuable and largely untapped source of liquidity. Companies that excel in working capital
management are more profitable, less dependent on external financing and have more flexibility to take
advantage of strategic opportunities.
Why companies should consider extra cash from working capital optimization?
To improve returns on capital (by lowering capital employed)
To mitigate risks of higher interest rates
To strengthen financial flexibility and improve credit ratings
To increase cash returns to shareholders
To send a strong positive signal to capital market
To speed up organic or inorganic growth

Focus on improving working capital levels emerging and significant

improvement possible

Historical changes in WC metrics

Cash to cash (C2C) conversion cycle represents how fast the business is able to monetise its investment in
the operating cycle of the business.

The results for Indian companies WC performance in 2013 show a slight improvement, with cash-to-cash
(C2C) dropping by 2% from its level of 2012. Had the oil and gas and metals and mining (O&G and M&M)
sectors been excluded, the C2C would have also fallen by 1%.

However, this overall level of improvement proved insufficient to reverse the deterioration in performance
seen in the previous three years. Between 2009 and 2013, the C2C of Indian companies was still up 21%
and 11% excluding the O&G and M&M sectors.
Chart 7: Change in C2C days, 20092013

Source: EY analysis, based on publicly available annual financial statements

Our analysis also reveals that Indian businesses are starting to realise the benefits on improving WC
management as they seek to raise cash and improve their operational efficiency, driven by the need to grow
their returns and repair their balance sheets, which have been stretched by their aggressive spending of
capital and acquisition strategies.

Compared with their peers in the US, Europe, Japan and other main Asian countries, Indian companies
remain at the bottom of WC performance.

Chart 8: Current WC metrics by sector across regions and countries

C2C India US Europe Japan Asia*

Auto parts 54 36 57 60 60
Building materials 42 56 51 84 65
Chemicals & fertilizers 83 64 67 87 53
Electric utilities 49 35 32 22 36
Food producers 66 47 32 53 57
Oil and gas 23 29 29 53 12
Pharmaceuticals 108 88 88 123 N.A.
Steel 68 67 78 87 71
Telecommunications -25 10 -3 46 -50

* excluding India and Japan

Source: EY analysis, based on latest publicly available annual financial statement
Our research also reveals a considerable disparity in the WC performance of Indian companies within the
same sector, which clearly indicates that there is potential for significant improvement. A high-level
comparative analysis conducted by EY reveals that Indian companies have up to INR5.3tn (US$96bn) of
cash unnecessarily tied up in their WC processes. This is equivalent to 12% of their aggregate sales.

At a time when Banks are struggling with high NPAs and their ability to fund is limited, working capital
optimisation offers a source of largely untapped liquidity. With the prevalent high interest rates this could
have a significant impact on the bottom line of companies.

Overview of challenges to drive operational efficiency

Most businesses find it difficult to balance profitable growth with optimum levels of working capital levels.

While variation in working capital performance can be partly explained by variations in business models and
geographic footprint, it also points to fundamental differences in the degree of managements focus on cash
and in the effectiveness of WC management processes against the backdrop of rapidly changing business,
financial, commodity and currency markets. Not treating working capital as an operational issue, poor system
data management, lack of awareness of global best practices, verticalised structure with poor organisational
ownership and insufficient focus on continuously adapting business policies and processes to a rapidly
changing environment appear to be the primary reason for the divergence in WC trends between India and
the US and Europe.

Typical reasons for excess deployment of working capital levels

Treating working capital as a finance issue and not an operational issue

Poor system data management such as payment terms and dates in system,
inaccurate inventory levels, and unallocated customer cash
Lack of organisational awareness of global best practices especially at the mid
level management
Vertical structure that does not enable organisational ownership of cross functional
issues such as raw material and spare parts levels
Insufficient focus on continuously adapting business policies and processes to a
rapidly changing environment

Road to improvement - The CFOs Guide

The CFOs role has so far been stereotyped in the past as a person who closely looks into accounts. But
with the changing times, CFOs have shown greater ability to execute on a number of areas, beyond the
traditional functional areas such as mergers and acquisitions and financing. In this highly challenging global
and domestic economic and financial environment, it is essential for firms to initiate comprehensive initiatives
with a view to improve ROCE of more specifically working capital deployed in the business. Program should
focus on capturing immediate savings and cash flow opportunities by reducing operating costs and net
working capital.
In our experience, most successful programmes have been led by CFO, but theyve included a cross-
functional team comprised of people from finance, sales, operations, procurement and IT. Improving demand
forecasting and inventory planning processes to lower inventory requirements, tracking accounts payable
performance by commodity and extending terms to industry benchmarks, and eliminating errors in the order
to delivery process to reduce disputes and improve accounts receivable performance are just a few of the
operational improvements that can dramatically reduce working capital requirements. Other essential
enablers include application of lean manufacturing and supply chain initiatives, effective management of
payment terms with customers and suppliers, closer collaboration with each of their partners in the
"extended enterprise," globalization of procurement, and taking an approach that balances cash, cost and
service levels.

All key operational levers need to be targeted and a robust supporting infrastructure set in place, including
focused metrics, aligned incentives and strong risk management policies. A tried and tested structured
approach focuses to:

1. Rapidly identify ambitious improvement potential by challenging current practices and business
norms

Quick wins that underpin immediate improvement and help in gathering organisational buy in
Process- and compliance-related improvement areas for operational improvement
Structural changes to make business operations asset and expense light

2. Focus on areas with highest impact and ease of implementation by defining and empowering clear
business owners

3. Design and pilot test improvement solutions leveraging existing global best practices

4. Dedicate resources and top management implementation focus for full benefits delivery

5. Ensure sustainability of results by improve organisational awareness and controls by establishing

right infrastructure including relevant metrics, incentives, SOPs, system and tools support

The secret of success is not to manage working capital or some of the cost elements but to change the
business and the organisation mind set for long terms benefits.
Wrapping it up: The concluding thought
The current business environment requires a strong focus on cost, and risk but even more important on cash
management. ROCE is a key metrics for most businesses and their investors. High debt and related interest
costs could eat into the bottom line and could force businesses to lose financial strength. Business that
manage profitable growth with optimum capital levels are the ones that appear as leaders. Working capital is
an area of value creation for most businesses.

There is a natural tendency among many companies to blame tough business environment for poor
performance as banks make lending tougher, customers struggle to pay on time, supply chains fail to keep
pace with falling demand, and suppliers seek to get early payments. Our experience shows that there still
are a number of areas within managements own influence that can be dramatically improved upon such as
timely billing, credit blocks and proactive collection, establishing responsive supply chain to adjust inventory
in real time with demand, and improved supplier and spend category management. This can lead to a
substantial and sustainable cash release in a relatively short period of time.

Indian companies need to take initiatives challenging the status quo in order to stay the course in the tough
economic environment. Till the economic situation changes, CFOs have to take the initiative to keep costs
low and investing in processes and upskilling resources to take on the good times when they return.

Ankur Bhandari, Partner, Working Capital Advisory Services, EY has

authored this article. This was published in IMAs CFO Connect magazine.

Article is based on EYs working capital management report (All Tied Up

2014) containing working capital performance of the top 500 cpompanies in
India. Article contains information in summary form and is therefore, intended
for general guidance only. It is not intended to be a substitute for detailed
research or the exercise of professional judgment.

You can get in touch with Ankur Bhandari on ankur.bhandari@in.ey.com