One of the most important areas in a firm is the day-to-day management of working capital. Adequacy or inadequacy of these funds would determine the efficiency with which the daily business may be carried on. Working capital refers to funds invested in current assets. A certain amount of funds are always tied up in raw material inventories, finished goods, sundry debtors and day-to-day cash requirement. Current assets are essential to use the fixed assets profitably. The working capital is the life-blood and nerve centre of a business firm.
A very big amount of working capital would mean that the company has idle funds. Since firms have to pay interest costs, having huge amount of idle funds leads to higher costs. This leads to low rate of return, implying less optimum use of resources. Vice versa, if the firm has inadequate funds, it leads to the risk of insolvency. The firm may not be able to pay its liabilities.
Current ratio (current assets/ current liabilities) is generally used as the indicator of working capital. A current ratio of 2: 1 is generally considered ideal. To supplement it, acid test ratio (liquid current assets/ current liabilities) of 1 is considered ideal. However, this cannot be a 100% benchmark as the current ratio may be even below 2 in a firm where the inventories are easily saleable and debtors may be as good as liquid cash. Optimum working capital depends on the nature of the business (capital intensive or not), production policies (seasonal nature), credit and inventory policies and market conditions (competitive, monopoly) and the expansion plans of the firm.
An ability to generate attractive returns on the capital employed on a consistent, long-term basis is the principal trait that almost all investors look for while investing in companies, irrespective of the sectors that they are in. However, the kind of assets that the companies employ might differ across sectors. Thus, while companies in sectors like auto and commodities might be fixed asset intensive, those in retail and engineering might be working capital intensive. For example, in case of engineering companies, the firms have to carry huge inventories. Also, they take time to collect the dues and hence have a high current ratio. This does not indicate idle funds, but a requirement to run the business. Wal-Mart, the world's most efficient company has negative working capital as products are delivered and sold to the customer before the company ever pays for them. Further, negative working capital is a sign of managerial efficiency in a business with low inventory and accounts receivable (which means they operate on an almost strictly cash basis). In any other situation, it is a sign that a company may be facing bankruptcy or serious financial trouble.
FMCG companies too, by virtue of being less intensive on the fixed asset side, might fall in the latter category. Hence, for companies in this sector, an efficient working capital management might differentiate the good company from the bad. Let us see how the different companies in this sector stack up when it comes to working capital management.
As seen from the chart above, Marico has the highest current ratio (we have not included cash and provisions) as compared to its peers. While comparing the working capital to sales, GSK Consumers, Dabur and Marico have positive working capital, while Nestle and HUL indicate managerial efficiency. They operate on a cash basis indicating their product strength.
Calculating the return on capital employed for these FMCG firms, we see that Nestle has the highest return. Nestle' s average current ratio of last 5 years is 0.7. This is mainly due to the fact that Nestle has excellent relationship with suppliers and customers. It can maintain its aggressive stance given its market leader status. Hence it has negative working capital to sales and highest ROCE amongst its peers. HUL follows next. Though working capital is not the only parameter affecting the profits and return on capital of firms, it is an important one.
Higher the amount of working capital, lower would be the return on capital employed, as capital turnover would be less. On the other end, lower the amount of working capital, higher would be the risk, as the company would not have adequate liquidity. Hence, it is important to strike a balance between risk and profitability.