SUMMARY OF THE CASE

The case describes the dilemma of a company in urgent need of funds in

order to secure an important contract. BBC Pvt. Ltd. is a chemical manufacturing
company under the management of Arpit Agarwal and Mukesh Kumar. The company
manufactures and sells stable bleaching powder. Through the use of adsorption,
BBC is able to manufacture a product which involves lower investment in the form of
fixed assets; although the product is also of an inferior quality, the company is able to
pass on that cost advantage to its end customers. This cost advantage enables BBC
to maintain its position in the market. In addition, the company sells the product
primarily on credit and is therefore a preferable option for buyers. BBC has followed
a traditional approach to working capital management. Its assets are much greater
than its liabilities. The company repays its creditors promptly before the credit period.
However, in terms of credit management, the company follows a casual approach. It
extends credit sales for large periods and its large inventory in the form of raw
material and finished goods has resulted in excessive blockage of working capital.
In 2012, the company bid on a contract with Indian Railways (IR) that will require
significant investment immediately. Agarwal needs to make decision about how to
secure adequate funds for the upgrade that BBC needs in order to fulfil its promising
contract.

ANALYSIS

1. Comment on the working capital policy followed by the company.

Class discussion can begin basic analysis of BBC’s working capital practices.
As the case notes, the company follows a traditional approach to working capital
management, which is evident from its liquidity position.

Working capital is the difference between current assets and current liabilities.
It can be defined as the amount of funds required for the day-to-day trading
operations of a business and pertains to maintaining an adequate level of liquid
resources. It is also a measure of a company’s efficiency and short-term financial
position. A company’s working capital policy directly affects the profitability, liquidity
and structural health of the organization. Most importantly, it determines the degree
of ‘operating risk’ involved in a business.
There are many factors that determine a company’s working capital
requirements. Students can be asked to discuss some of these factors, such as: 

General Nature of the Business: The working capital requirement of a firm depends
upon the type of business involved. 
Size of the Business: The larger the business, the greater the amount of working
capital required. 
Production Policy: The company’s production policy determines the amount of
working capital required. If the policy is to maintain inventory in advance, then the
amount of working capital required would be high. 
Operating Cycle: The length of the operating cycle determines the working capital of
a company. The longer the operating cycle, the higher the amount of working capital
required (and vice versa). 
Credit Policy: A liberal credit policy requires more working capital than a stringent
credit policy.

The instructor can then introduce a discussion on the various approaches to

working capital management. There are two basic types of financing that a firm can
adopt for its current assets: long-term financing and short-term financing. Depending

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 on the mix of short- and long-term financing, the working capital approach followed
by a company may be broadly referred to as either:

 A conservative approach: The financing policy of the firm is said to be
conservative when it depends more on long-term funds than short-term funds for
financing needs. 
 An aggressive approach: An aggressive policy is one in which a firm uses more
short-term financing than long-term financing.

BBC’s current assets are mainly in the form of inventories, sundry debtors,
cash and bank balance and loans and advances. The company’s levels of current
assets are very high, as represented by high current ratio and quick ratio. The current
asset as a percentage of total asset is around 65 per cent for BBC, whereas the
average ratio in the manufacturing sector is 30 per cent.
At this point the class discussion can be guided towards the need for an
‘optimum’ level of working capital in a company. Excessive working capital may prove
disadvantageous to the company for a variety of reasons, such as:

1. Excessive working capital means idle funds which yield no returns for the
business. 2. It may lead to theft, waste and losses.
3. It can result in excess debtors/receivables and poor credit policy.
4. It may lead to decline in the value of the company’s shares because of low return
on capital employed (ROCE).

On the other hand, a shortage of working capital is equally undesirable, as it means

insufficient funds for business operations and may result in discontinuance of
business in the long run.
In contrast to BBC, which has a large amount of working capital, some
companies maintain negative working capital through effective credit policy. These
companies have high deferral periods and shorter collection periods.
Such companies also make quick sales and invest the realized cash in commercial
papers and certificates of deposits that earn them good returns in the short term.
The instructor can now lead the discussion towards the current asset
utilization in the domain of working capital management. BBC’s levels of current
assets are very high and it eventually led to an unproductive blockage of funds. The
ratio of current assets to total assets has been in the range of 62 to 66 per cent from
2009 to 2011, whereas the benchmark of the manufacturing sector is 30 per cent.
This indicates a high degree of ‘operating risk.’ The company should reduce its
current assets so that there are funds available for contingencies.
2. The inventory turnover ratio (ITR) decreases from 2009-2011. Calculate
ITR and analyze the efficiency of the company’s inventory management.

A large amount of BBC’s working capital is blocked in the form of inventories.

The company’s financial statements reflect an enormous increase in these inventory
levels from 2009 to 2011.
As the case notes, accumulated inventory can be categorized into three main
groups: raw materials, finished goods and packing materials. From 2009-2011, the
levels of all three of these types of inventory have risen significantly. Although such
high levels of inventory eliminate the possibility of disruptions in manufacturing due to
a stockout, it has led to wastage and blockage of BBC’s working capital.
Instead of this practice, BBC could follow a lean manufacturing system like
just-in-time (JIT).4 In a JIT system, materials are ordered as and when they are
needed. The necessity of carrying large amounts of stock is therefore eliminated,
saving storage and other related costs.

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 BBC follows the first-in-first-out (FIFO) method of inventory valuation.5 Under
this method, it is assumed that materials are issued to production in order of their
arrival. This implies that inventory costs will be computed on the assumption that
goods sold or materials consumed are those which have been stored for the longest
period of time; therefore, those remaining in stock represent the latest purchase or
production. In this way, period-end inventory will be closer to market value. The FIFO
method will undercharge the production in case of inflation and overcharge in case of
falling prices. The balance sheet may reflect the true value, but the income statement
may be distorted under the two price-level situations.
Therefore, a better way of inventory valuation may be the concept of
weighted average.6 This method of inventory valuation attempts to moderate the
extremes of FIFO with the objective of arriving at a perfect combination of realistic
cost of goods sold and period-end inventory. Weighted-average valuation averages
the cost of all units purchased at various points in time and at various periods during
the accounting year. Weighted average is calculated by multiplying the unit of cost by
each lot size and then dividing the resulting figure by the total number of units
purchased.
The instructor can move the discussion to the high inventory maintained by
BBC. Clearly, this method of inventory valuation is not beneficial for the company as
it represents blocked funds and may lead to costs associated with deterioration and
wastage. When the company is trying to muster funds for the IR contract, this method
of valuation will only restrict funds even more.

3. Evaluate the company’s cash position with focus on its credit policy
towards receivables and payables.
Cash management a critical area for small companies. It involves managing
the monies of the firm to maximize cash availability and interest income on any idle
funds.7 Management should continuously work to maintain cash at optimum levels.
Whenever there is excess cash, it should be placed in liquid short-term investments,
such as call money, intercorporate deposits, commercial papers and certificates of
deposits, instead of remaining idle. This will not only help the company in meeting its
cost of capital but will also ensure that funds are available at all times, acting as a
cushion for the company in contingencies like the one which BBC currently faces
(largely because of inefficient management of payables and receivables).
Most of BBC’s sales have been in the form of credit. This has resulted in large
amounts of receivables. A significant amount of the company’s funds are blocked in
the form of these receivables. BBC has been very liberal in extending credit sales to
its customers, which have remained unrealized for as long as two years. A major
area of concern for the company is therefore receivables management. Receivables
management is one of the essential parameters for effective liquidity in a business.
The instructor can now move the discussion towards the significance of
liquidity position regarding receivables’ management. The class can review the data
in Exhibits 1-3 of the case and see that BBC enjoys a very high liquidity position,
which is described by its current ratio and quick ratio. For the financial year 2010/11,
the company’s current and quick ratios were 15.8 and 12.8, respectively. However,
BBC’s current and quick ratios are high only because of increased current assets,
which are not beneficial for the company. The major accounting head here is debtors
only second to inventory.
BBC needs a sound collection policy because its customers do not always
pay the firm’s bills promptly. Collection efforts should aim at accelerating the
collections from slow payers and reducing bad-debt losses. Students should
understand that a sound collection policy should ensure prompt and regular
collections. By not collecting promptly, the company not only faces the problem of
insufficient cash for its day-to-day operations but also loses the interest that it would
have earned by investing that cash in various liquid short-term investments. There

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 can be a short discussion at this point on the concept of ‘opportunity cost,’ as BBC is
incurring an opportunity cost in neglecting to collect payments on time.
Accounts payable is another useful working capital financing option.
Accounts payable includes trade credit and accrued expenses of the business.
These funds represent an alternative to the funds raised through formal institutional
channels. This is because the suppliers, being close to the buyers, have better
information about the creditworthiness of a buyer and also enjoy greater control over
the buyer than institutional financing agencies. Hence, they can offer better terms to
the buyers in extending trade credit. The longer the time allowed for payment, the
lower the net present value of such payment and the higher the value to the firm.
Thus, a company on a growth trajectory should have higher levels of current
liabilities.
BBC has not used its creditors’ terms to its advantage. The company has
been quick in repaying its debts. This can be inferred from the significant decrease in
the sundry creditors of the firm from 2009 to 2011, which has resulted in a tight
liquidity position of the company. If the company makes full utilization of the credit
being extended by the suppliers, it can lead to availability of extra funds to carry on
day-to-day operations. Thus, a company willing to pursue expansion should exploit
its available credit as long as the trade creditor allows.

4. Is BBC a growing company? Which areas should be improved in the

company for future growth?
BBC cannot be called a growing company. The company’s gross block has
been continuously decreasing at a significant rate. This means that instead of
growing, the company is actually shrinking — and at a rapid rate. There are many
areas that require improvement if the company aspires for a turnaround.
The company needs to put extensive work into areas of inventory and
receivables management in order to see a turnaround. Its sales have not grown from
2009 -2011. Significant efforts are required to convert the finished goods into sales.
This will not only reduce BBC’s inventory levels but will also help the company in
growing further.
BBC should take full advantage of the ‘grace’ periods offered by its suppliers
and try to reduce its credit periods to customers for better liquidity. Due to wide
fluctuations in the price of raw materials, the company is unable to predict suppliers’
cost and the actual funds required. This has been another major hindrance in BBC’s
credit management. In terms of debtors’ and suppliers’ management, the company’s
credit management is not very sound and needs continued improvement.
Operating cost is a major factor for working capital. BBC has the advantage
of low fixed and operating costs due to its adsorption technique of production, which
allows the company to pass on this cost advantage to its consumers. It should build
further on this for long-term viability.
The orders from private accounts are smaller than those from the
government. Accordingly, BBC should try to secure more government orders in the
long term, as it is doing. If BBC succeeds in winning the current IR contract, this may
bring the company back to the growth trajectory.
The company should try to convince its bank manger to grant loans at a
lower rate of interest and softer terms due to past tie-ups for infusing the sorely
needed capital into the business (and for the IR contract in particular). Industry giants
like the Aditya Birla Group, the DCM Group, Grasim Industries Limited, etc. are
BBC’s suppliers of raw materials as well as the company’s major competitors.
Survival in this atmosphere is a struggle for BBC and will depend upon a sound
working capital.
As part of a hazardous industry, BBC must be very careful about
environmental issues. Extra safety measures are required for this, which in turn

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 depend upon availability of funds. This will need to be included in the company’s plan
for long-term growth.
The instructor can conclude the discussion with a note on the significance of
efficient working capital management for long-term growth and sustainability as well
as with smooth day-to-day operations.

WHAT HAPPENED

It may be worthwhile for the instructor to know that the company could not
manage the required working capital for the railways contract. Neither did the
bankers ease the terms of fresh credit nor could the company realize the blocked
funds. The company still struggles to finance its working capital requirements.

FROM OTHER SOURCE HEHE

Under the case,BBC a Chemical manufacturing company established in 2004, with

its registered office located in Bangalore, managed by Agarwal and Mukesh, had an
opportunity to establish contracts with Indian Railways was present to the company.
Which would enable them to expand its reach to other industries available in the
Indian market. However, it was evaluated that, to successfully gain the contract with
IR, BBC would need to perform certain modification in its business processes.Such
as establishing an onsite IR office, along with establishing a Warehouse,
workshop.By developing appropriate cash reserves to meet and continues its daily
production activities.Hence, it can be evaluated that, these developments conducted,
to meet the criteria of gaining the contract would expose the organization to
significant costs amounting to INR2,400,000. Additionally, the cash flow valuation
model is conducted, under certain Assumptions illustrated in the Exhibit below. Which
help us to determine the appropriate cash flows that, would be generated, if BBC
operated under the Contract with IR. It was assumed that, the contract expected life
was assumed to be 10 years and by the year 2012, the sales of BBC would increase
by 30%.From the average sales over the previous three year period, with an annual
sales growth rate of 2.5%.Moreover, it was assumed that, the cost of Sales would
increase by 12.5 in 2012, and would remain constant over the 10 year period and the
initial investment of INR 1.2 million would be acquired on loan incurring a 14.85%
amounting to 148,850.While the discount rate would be 10%. Additionally, the cash
reserve required would need to be maintain over the 10 year period.Which, in turn,
would help us to estimate the cash flows over the 10-year period, as illustrated in the
excel file. Then the cash flow generated would be discounted at 10% rate of return,
to estimate the present values of cash flows and in turn, the net present value of the
potential contract amount to a positive 7,988,401.

In addition to this, a common size income statement along with trend & ratio analysis
was used to assess that, BBC was facing certain working capital challenges, which
could be caused by its decreasing sales revenues from 2009 to 2011. Which meant
that, due to the decline in its sales revenues generation caused the organization, to
register higher raw material turnover ratios in days. As BBC was unable to efficiently
convert in raw material purchased on credit in to finished products, causing it to incur
significant costs in terms of raw material inventory holding costs and significantly
increase its inventory turnover ratios in days. Furthermore, it can be evaluated that,
BBC had been able to decrease its finished goods inventory turnover in days from

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 2010 at 20.8 to 2011 at 13.47, while it had shown a consideration increase from the
2009 at 4.87. Which meant that, in the year 2009, BBC was most efficient in
converting its finished goods in to sales revenues compared to its two subsequent
years. Additionally, it can be assessed that, BBC had significant decreased its
account payable turnover ratios in days from the year 2009 onwards. Which could
have contributed towards evaluation the enterprise value of the organization, further
enhancing the challenges in its working capital. The receivable turnover in days has
been significantly decreased from the years 2010 at 15.26 to 9.64 in 2011 whereas,
the receivable turnover was at 7.92 in 2009.Which meant that, the company was
more efficient in converting its receivables from sales into cash in 2011 compared to
2010, but less efficient compared to the year 2009.Moreover, it can be evaluated
that, the net profit margins of BBC has declined over the years, which could
comprise the ability of BBC to payoff it's liabilities, while maintaining sufficient
working capital to spend the amount of investment needed to successfully avail or
gain the contracts with IR. Hence, an imbalance between BBCs ratios was identified
such as, raw material turnover were to high, while the finished goods turnover were
appropriate in the year 2011.

Therefore, it can be recommended to Agarwal that, he should improve the working

capital situation of BCC by incorporating effective and efficient strategies and policies
in term of credit of credit policies given to its clients or borrowers, while exhibiting
stern controls over their policies developed. Which would significantly decrease its
receivable turnover in days, enhancing its working capital situation better enabling
BBC to payoff its liabilities, while effectively fulfilling the criteria for the contract of IR
by spending capital investment from its working capital generated. Furthermore,
under the assumption to estimate the NPV of the proposed contract, would further
enable BBC to better its Working capital Requirement though the generation of
positive NPV.

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