Analyzing Your Financial Ratios

Analyzing Your Financial Ratios
Overview Any successful business owner is constantly evaluating the performance of his or her company, comparing it with the company's historical figures, with its industry competitors, and even with successful businesses from other industries. To complete a thorough examination of your company's effectiveness, however, you need to look at more than just easily attainable numbers like sales, profits, and total assets. You must be able to read between the lines of your financial statements and make the seemingly inconsequential numbers accessible and comprehensible. This massive data overload could seem staggering. Luckily, there are many well-tested ratios out there that make the task a bit less daunting. Comparative ratio analysis helps you identify and quantify your company's strengths and weaknesses, evaluate its financial position, and understand the risks you may be taking. As with any other form of analysis, comparative ratio techniques aren't definitive and their results shouldn't be viewed as gospel. Many off-the-balance-sheet factors can play a role in the success or failure of a company. But, when used in concert with various other business evaluation processes, comparative ratios are invaluable. This discussion contains descriptions and examples of the eight major types of ratios used in financial analysis: Income, Profitability, Liquidity, Working Capital, Bankruptcy, Long-Term Analysis, Coverage, and Leverage. Outline:

I. II. III. IV. V. VI. VII. VIII. IX. X. XI. XII. XIII. XIV.

Purposes and Considerations of Ratios and Ratio Analysis Types of Ratios Income Ratios Profitability Ratios Net Operating Profit Ratios Liquidity Ratios Working Capital Ratios Bankruptcy Ratios Long-Term Analysis Coverage Ratios Total Coverage Ratios Leverage Ratios Common-Size Statement Resources

I. Purposes and Considerations of Ratios and Ratio Analysis Ratios are highly important profit tools in financial analysis that help financial analysts implement plans that improve profitability, liquidity, financial structure, reordering, leverage, and interest coverage. Although ratios report mostly on past performances, they can be predictive too, and provide lead indications of potential problem areas. Ratio analysis is primarily used to compare a company's financial figures over a period of time, a method sometimes called trend analysis. Through trend analysis, you can identify trends, good and bad, and

adjust your business practices accordingly. You can also see how your ratios stack up against other businesses, both in and out of your industry. There are several considerations you must be aware of when comparing ratios from one financial period to another or when comparing the financial ratios of two or more companies. y If you are making a comparative analysis of a company's financial statements over a certain period of time, make an appropriate allowance for any changes in accounting policies that occurred during the same time span. When comparing your business with others in your industry, allow for any material differences in accounting policies between your company and industry norms. When comparing ratios from various fiscal periods or companies, inquire about the types of accounting policies used. Different accounting methods can result in a wide variety of reported figures. Determine whether ratios were calculated before or after adjustments were made to the balance sheet or income statement, such as non-recurring items and inventory or pro forma adjustments. In many cases, these adjustments can significantly affect the ratios. Carefully examine any departures from industry norms.

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Back to Outline II. Types of Ratios Income Profitability Liquidity Working Capital Bankruptcy Long-Term Analysis Coverage Leverage Back to Outline III. Income Ratios Turnover of Total Operating Assets Net Sales = Turnover of Total Operating Assets Ratio Total Operating Assets* Obviously, an increase in sales will necessitate more operating assets at some point (sales may rise without additional investment within a given range, however); conversely, an inadequate sales volume may call for reduced investment. Turnover of Total Operating Assets or sales to investment in total operating assets tracks over-investment in operating assets. *Total operating assets = total assets - (long-term investments + intangible assets) Note: This ratio does not measure profitability. Remember, over-investment may result in a lack of adequate profits. Net Sales to Tangible Net Worth

Net Sales Tangible Net Worth*

= Net Sales to Tangible Net Worth Ratio

This ratio indicates whether your investment in the business is adequately proportionate to your sales volume. It may also uncover potential credit or management problems, usually called "overtrading" and "undertrading." Overtrading, or excessive sales volume transacted on a thin margin of investment, presents a potential problem with creditors. Overtrading can come from considerable management skill, but outside creditors must furnish more funds to carry on daily operations. Undertrading is usually caused by management's poor use of investment money and their general lack of ingenuity, skill or aggressiveness. *Tangible Net Worth = owner's equity - intangible assets Gross Margin on Net Sales Gross Margin* = Gross Margin on Net Sales Ratio Net Sales By analyzing changes in this figure over several years, you can identify whether it is necessary to examine company policies relating to credit extension, markups (or markdowns), purchasing, or general merchandising (where applicable). *Gross Margin = net sales - cost of goods sold Note: An increase in gross margin may result from higher sales, lower cost of goods sold, an increase in the proportionate volume of higher margin products, or any combination of these variables. Operating Income to Net Sales Ratio Operating Income Net Sales = Operating Income to Net Sales Ratio

This ratio reveals the profitability of sales resulting from regular business as well as buying, selling, and manufacturing operations. Note:Operating income derives from ordinary business operations and excludes other revenue (losses), extraordinary items, interest on long-term obligations, and income taxes. Acceptance Index Applications Accepted = Acceptance Index Applications Submitted Obviously, a high sales volume that comes from just two or three major accounts is much riskier than the same volume coming from a large number of customers. Losing one out of three major accounts is disastrous, while losing one out of 150 is routine. A growing firm should try to spread this risk of

dependency through active sales, promotion, and credit departments. Although the quality of customers stems from your general management policy, the quantity of newly opened accounts is a direct reflection on your sales and credit efforts. Note: This index of effectiveness does not apply to every type of business. Back to Outline IV. Profitability Ratios Closely linked with income ratios are profitability ratios, which shed light upon the overall effectiveness of management regarding the returns generated on sales and investment. Gross Profit on Net Sales Net Sales - Cost of Goods Sold Net Sales

= Gross Profit on Net Sales Ratio

Does your average markup on goods normally cover your expenses, and therefore result in a profit? This ratio will tell you. If your gross profit rate is continually lower than your average margin, something is wrong! Be on the lookout for downward trends in your gross profit rate. This is a sign of future problems for your bottom line. Note: This percentage rate can ² and will ² vary greatly from business to business, even those within the same industry. Sales, location, size of operations, and intensity of competition are all factors that can affect the gross profit rate. Back to Outline V. Net Operating Profit Ratios Net Profit on Net Sales EAT* = Net Profit on Net Sales Ratio Net Sales This ratio provides a primary appraisal of net profits related to investment. Once your basic expenses are covered, profits will rise disproportionately greater than sales above the break-even point of operations. *EAT= earnings after taxes Note: Sales expenses may be substituted out of profits for other costs to generate even more sales and profits. Net Profit to Tangible Net Worth EAT Tangible Net Worth = Net Profit to Tangible Net Worth Ratio

This ratio acts as a complementary appraisal of net profits related to investment. This ratio sizes up the ability of management to earn a return. Net Operating Profit Rate Of Return EBIT = Net Operating Profit Rate of Return Ratio Tangible Net Worth Your Net Operating Profit Rate of Return ratio is influenced by the methods of financing you utilize. Notice that this ratio employs earnings before interest and taxes, not earnings after taxes. Profits are taken after interest is paid to creditors. A fallacy of omission occurs when creditors support total assets. Note: If financial charges are great, compute a net operating profit rate of return instead of return on assets ratio. This can provide an important means of comparison. Management Rate Of Return Operating Income Fixed Assets + Net Working Capital

= Management Rate of Return Ratio

This profitability ratio compares operating income to operating assets, which are defined as the sum of tangible fixed assets and net working capital. This rate, which you may calculate for your entire company or for each of its divisions or operations, determines whether you have made efficient use of your assets. The percentage should be compared with a target rate of return that you have set for the business. Earning Power Net Sales EAT X = Earning Power Ratio Tangible Net Worth Net Sales The Earning Power Ratio combines asset turnover with the net profit rate. That is, Net Sales to Tangible Net Worth (see "Income Ratios") multiplied by Net Profit on Net Sales (see ratio above). Earning power can be increased by heavier trading on assets, by decreasing costs, by lowering the break-even point, or by increasing sales faster than the accompanying rise in costs. Note: Sales hold the key. Back to Outline VI. Liquidity Ratios While liquidity ratios are most helpful for short-term creditors/suppliers and bankers, they are also important to financial managers who must meet obligations to suppliers of credit and various government agencies. A complete liquidity ratio analysis can help uncover weaknesses in the financial position of your business. Current Ratio

Current Assets* Current Liabilities*

= Current Ratio

Popular since the turn of the century, this test of solvency balances your current assets against your current liabilities. The current ratio will disclose balance sheet changes that net working capital will not. *Current Assets = net of contingent liabilities on notes receivable *Current Liabilities = all debt due within one year of statement data Note: The current ratio reveals your business's ability to meet its current obligations. It should be supplemented with the other ratios listed below, however. Quick Ratio Cash + Marketable Securities + Accounts Receivable (net) Current Liabilities

= Quick Ratio

Also known as the "acid test," this ratio specifies whether your current assets that could be quickly converted into cash are sufficient to cover current liabilities. Until recently, a Current Ratio of 2:1 was considered standard. A firm that had additional sufficient quick assets available to creditors was believed to be in sound financial condition. Note: The Quick Ratio assumes that all assets are of equal liquidity. Receivables are one step closer to liquidity than inventory. However, sales are not complete until the money is in hand. Absolute Liquidity Ratio Cash + Marketable Securities Current Liabilities

= Absolute Liquidity Ratio

A subsequent innovation in ratio analysis, the Absolute Liquidity Ratio eliminates any unknowns surrounding receivables. Note: The Absolute Liquidity Ratio only tests short-term liquidity in terms of cash and marketable securities. Basic Defense Interval (Cash + Receivables + Marketable Securities) = Basic Defense Interval (Operating Expenses + Interest + Income Taxes) / 365 If for some reason all of your revenues were to suddenly cease, the Basic Defense Interval would help determine the number of days your company can cover its cash expenses without the aid of additional financing. Receivables Turnover Total Credit Sales = Receivables Turnover Ratio

Average Receivables Owing Another indicator of liquidity, Receivables Turnover Ratio can also indicate management's efficiency in employing those funds invested in receivables. Net credit sales, while preferable, may be replaced in the formula with net total sales for an industry-wide comparison. Note: Closely monitoring this ratio on a monthly or quarterly basis can quickly underscore any change in collections. Average Collection Period (Accounts + Notes Receivable) = Average Collection Period (Annual Net Credit Sales) / 365 The Average Collection Period (ACP) is another litmus test for the quality of your receivables business, giving you the average length of the collection period. As a rule, outstanding receivables should not exceed credit terms by 10-15 days. If you allow various types of credit transactions, such as a retail outlet selling both on open credit and installment, then the ACP must be calculated separately for each category. Note: Discounted notes which create contingent liabilities must be added back into receivables. Inventory Turnover Cost of Goods Sold Average Inventory = Inventory Turnover Ratio

Rule of Thumb: Multiply your inventory turnover by your gross margin percentage. If the result is 100 percent or greater, your average inventory is not too high. Back to Outline VII. Working Capital Ratios Many believe increased sales can solve any business problem. Often, they are correct. However, sales must be built upon sound policies concerning other current assets and should be supported by sufficient working capital. There are two types of working capital: gross working capital, which is all current assets, and net working capital, which is current assets less current liabilities. If you find that you have inadequate working capital, you can correct it by lowering sales or by increasing current assets through either internal savings (retained earnings) or external savings (sale of stock). Following are ratios you can use to evaluate your business's net working capital. Working Capital Ratio Use "Current Ratio" in the section on "Liquidity Ratios." This ratio is particularly valuable in determining your business's ability to meet current liabilities.

Working Capital Turnover Net Sales Net Working Capital

= Working Capital Turnover Ratio

This ratio helps you ascertain whether your business is top-heavy in fixed or slow assets, and complements Net Sales to Tangible Net Worth (see "Income Ratios"). A high ratio could signal overtrading. Note: A high ratio may also indicate that your business requires additional funds to support its financial structure, top-heavy with fixed investments. Current Debt to Net Worth Current Liabilities Tangible Net Worth

= Current Debt to Net Worth Ratio

Your business should not have debt that exceeds your invested capital. This ratio measures the proportion of funds that current creditors contribute to your operations. Note: For small businesses a ratio of 60 percent or above usually spells trouble. Larger firms should start to worry at about 75 percent. Funded Debt to Net Working Capital Long-Term Debt = Funded Debt to Net Working Capital Ratio Net Working Capital Funded debt (long-term liabilities) = all obligations due more than one year from the balance sheet date Note: Long-term liabilities should not exceed net working capital. Back to Outline VIII. Bankruptcy Ratios Many business owners who have filed for bankruptcy say they wish they had seen some warning signs earlier on in their company's downward spiral. Ratios can help predict bankruptcy before it's too late for a business to take corrective action and for creditors to reduce potential losses. With careful planning, predicted futures can be avoided before they become reality. The first five bankruptcy ratios in this section can detect potential financial problems up to three years prior to bankruptcy. The sixth ratio, Cash Flow to Debt, is known as the best single predictor of failure. Working Capital to Total Assets Net Working Capital = Working Capital to Total Assets Ratio Total Assets

This liquidity ratio, which records net liquid assets relative to total capitalization, is the most valuable indicator of a looming business disaster. Consistent operating losses will cause current assets to shrink relative to total assets. Note: A negative ratio, resulting from negative net working capital, presages serious problems. Retained Earnings to Total Assets Retained Earnings Total Assets

= Retained Earnings to Total Assets Ratio

New firms will likely have low figures for this ratio, which designates cumulative profitability. Indeed, businesses less than three years old fail most frequently. Note: A negative ratio portends cloudy skies. However, results can be distorted by manipulated retained earnings (earned surplus) data. EBIT to Total Assets EBIT = EBIT to Total Assets Ratio Total Assets How productive are your business's assets? Asset values come from earning power. Therefore, whether or not liabilities exceed the true value of assets (insolvency) depends upon earnings generated. Note: Maximizing rate of return on assets does not mean the same as maximizing return on equity. Different degrees of leverage affect these separate conclusions. Sales to Total Assets Total Sales Total Assets

= Sales to Total Assets Ratio

See "Turnover Ratio" under "Profitability Ratios." This ratio, which uncovers management's ability to function in competitive situations while not excluding intangible assets, is inconclusive if studied by itself. But when viewed alongside Working Capital to Total Assets, Retained Earnings to Total Assets, and EBIT to Total Assets, it can confirm whether your business is in imminent danger. Note: A result of 200 percent is more reassuring than one of 100 percnt. Equity to Debt Market Value of Common + Preferred Stock Total Current + Long-Term Debt

= Equity to Debt Ratio

This ratio shows you by how much your business's assets can decline in value before it becomes insolvent.

Note: Those businesses with ratios above 200 percent are safest. Cash Flow to Debt Cash Flow* Total Debt

= Cash Flow to Debt Ratio

Also, refer to "Debt Cash Flow Coverage Ratio" in the section on "Coverage Ratios." Since debt does not materialize as a liquidity problem until its due date, the closer to maturity, the greater liquidity should be. Other ratios useful in predicting insolvency include Total Debt to Total Assets (see "Leverage Ratios" below) and Current Ratio (see "Liquidity Ratios"). *Cash flow = Net Income + Depreciation Note: Because there are various accounting techniques of determining depreciation, use this ratio for evaluating your own company and not to compare it to other companies. Back to Outline IX. Long-Term Analysis Current Assets to Total Debt Current Assets = Current Assets to Total Debt Ratio Current + Long-Term Debt This ratio determines the degree of protection linked to short- and long-term debt. More net working capital protects short-term creditors. Note: A high ratio (significantly above 100 percent) shows that if liquidation losses on current assets are not excessive, long-range debtors can be paid in full out of working capital. Stockholders' Equity Ratio Stockholders' Equity Total Assets

= Stockholders' Equity Ratio

Relative financial strength and long-run liquidity are approximated with this calculation. A low ratio points to trouble, while a high ratio suggests you will have less difficulty meeting fixed interest charges and maturing debt obligations. Total Debt to Net Worth Current + Deferred Debt Tangible Net Worth

= Total Debt to Net Worth Ratio

Rarely should your business's total liabilities exceed its tangible net worth. If it does, creditors assume more risk than stockholders. A business handicapped with heavy interest charges will likely lose out to its better financed competitors. Back to Outline X. Coverage Ratios Times Interest Earned EBIT = Times Interest Earned Ratio I EBIT = earnings before interest and taxes I = dollar amount of interest payable on debt The Times Interest Earned Ratio shows how many times earnings will cover fixed-interest payments on long-term debt. Back to Outline XI. Total Coverage Ratios EBIT I + s 1-h = Total Coverage Ratio

I = interest payments s = payment on principal figured on income after taxes (1 - h) This ratio goes one step further than Times Interest Earned, because debt obliges the borrower to not only pay interest but make payments on the principal as well. Back to Outline XII. Leverage Ratios This group of ratios calculates the proportionate contributions of owners and creditors to a business, sometimes a point of contention between the two parties. Creditors like owners to participate to secure their margin of safety, while management enjoys the greater opportunities for risk shifting and multiplying return on equity that debt offers. Note: Although leverage can magnify earnings, it exaggerates losses. Equity Ratio Common Shareholders' Equity Total Capital Employed

= Equity Ratio

The ratio of common stockholders' equity (including earned surplus) to total capital of the business shows how much of the total capitalization actually comes from the owners.

Note: Residual owners of the business supply slightly more than one half of the total capitalization. Debt to Equity Ratio Debt + Preferred Long-Term Common Stockholders' Equity

= Debt to Equity Ratio

A high ratio here means less protection for creditors. A low ratio, on the other hand, indicates a wider safety cushion (i.e., creditors feel the owner's funds can help absorb possible losses of income and capital). Total Debt to Tangible Net Worth If your business is growing, track this ratio for insight into the distributive source of funds used to finance expansion. Debt Ratio Current + Long-Term Debt = Debt Ratio Total Assets What percentage of total funds are provided by creditors? Although creditors tend to prefer a lower ratio, management may prefer to lever operations, producing a higher ratio. Times Interest Earned Refer to "Coverage Ratios" Back to Outline XIII. Common-Size Statement When performing a ratio analysis of financial statements, it is often helpful to adjust the figures to common-size numbers. To do this, change each line item on a statement to a percentage of the total. For example, on a balance sheet, each figure is shown as a percentage of total assets, and on an income statement, each item is expressed as a percentage of sales. This technique is quite useful when you are comparing your business to other businesses or to averages from an entire industry, because differences in size are neutralized by reducing all figures to commonsize ratios. Industry statistics are frequently published in common-size form. When comparing your company with industry figures, make sure that the financial data for each company reflect comparable price levels, and that it was developed using comparable accounting methods, classification procedures, and valuation bases. Such comparisons should be limited to companies engaged in similar business activities. When the financial policies of two companies differ, these differences should be recognized in the evaluation of comparative reports. For example, one company leases its properties while the other purchases such items; one company finances its operations using long-term borrowing while the other relies primarily on funds supplied by stockholders and by earnings. Financial statements for two companies under these circumstances are not wholly comparable.

Example Common-Size Income Statement 2008 Sales Cost of Sales Gross Profit Expenses Taxes Profit 100% 65% 35% 27% 2% 6% 2009 100% 68% 32% 27% 1% 4% 2010 100% 70% 30% 26% 1% 3%

Financial Statements: Working Capital Printer friendly version (PDF format) By David Harper (Contact David)

A recurring theme in this series is the importance of investors shaping their analytical focus according to companies' business models. Especially when time is limited, it's smart to tailor your emphasis so it's in line with the economic drivers that preoccupy the company's industry. It's tough to get ahead of the "investing pack" if you are reacting to generic financial results such as earnings per share (EPS) or revenue growth - after they've already been reported. For any given business, there are usually some key economic drivers, or leading indicators, that capture and reflect operational performance and eventually translate into lagging indicators such as EPS. For certain businesses, trends in the working capital accounts can be among these key leading indicators of financial performance. Where is Working Capital Analysis Most Critical? On the one hand, working capital is always significant. This is especially true from the lender's or creditor's perspective, where the main concern is defensiveness: can the company meet its short-term obligations, such as paying vendor bills? But from the perspective of equity valuation and the company's growth prospects, working capital is more critical to some businesses than to others. At the risk of oversimplifying, we could say that the models of these businesses are asset or capital intensive rather than service or people intensive. Examples of service intensive companies include H&R Block, which provides personal tax services, and Manpower, which provides employment services. In asset intensive sectors, firms such as telecom and pharmaceutical companies invest heavily in fixed assets for the long term, whereas others invest capital primarily to build and/or buy inventory. It is the latter type of business - the type that is capital intensive with a focus on inventory rather than fixed assets - that deserves the greatest attention when it comes to working capital analysis. These businesses tend to involve retail, consumer goods and technology hardware, especially if they are low-cost producers or distributors. Working capital is the difference between current assets and current liabilities:

Inventory

Inventory balances are significant because inventory cost accounting impacts reported gross profit margins. (For an explanation of how this happens, see Inventory Valuation For Investors: FIFO and LIFO.) Investors tend to monitor gross profit margins, which are often considered a measure of the value provided to consumers and/or the company's pricing power in the industry. However, we should be alert to how much gross profit margins depend on the inventory costing method. Below we compare three accounts used by three prominent retailers: net sales, cost of goods sold (COGS) and the LIFO reserve.

Walgreen's represents our normal case and arguably shows the best practice in this regard: the company uses LIFO inventory costing, and its LIFO reserve increases year over year. In a period of rising prices, LIFO will assign higher prices to the consumed inventory (cost of goods sold) and is therefore more conservative. Just as COGS on the income statement tends to be higher under LIFO than under FIFO, the inventory account on the balance sheet tends to be understated. For this reason, companies using LIFO must disclose (usually in a footnote) a LIFO reserve, which when added to the inventory balance as reported, gives the FIFO-equivalent inventory balance.

Because GAP Incorporated uses FIFO inventory costing, there is no need for a "LIFO reserve." However, GAP's and Walgreen's gross profit margins are not commensurable. In other words, comparing FIFO to LIFO is not like comparing apples to apples. GAP will get a slight upward bump to its gross profit margin because its inventory method will tend to undercount the cost of goods. There is no automatic solution for this. Rather, we can revise GAP's COGS (in dollar terms) if we make an assumption about the inflation rate during the year. Specifically, if we assume that the inflation rate for the inventory was R% during the year, and if "Inventory Beginning" in the equation below equals the inventory balance under FIFO, we can re-estimate COGS under LIFO with the following equation:

Kohl's Corporation uses LIFO, but its LIFO reserve declined year over year - from $4.98 million to zero. This is known as LIFO liquidation or liquidation of LIFO layers, and indicates that during the fiscal year, Kohl's sold or liquidated inventory that was held at the beginning of the year. When prices are rising, we know that inventory held at the beginning of the year carries a lower cost (because it was purchased in prior years). Cost of goods sold is therefore reduced, sometimes significantly. Generally, in the case of a sharply declining LIFO reserve, we can assume that reported profit margins are upwardly biased to the point of distortion. Cash Conversion Cycle The cash conversion cycle is a measure of working capital efficiency, often giving valuable clues about the underlying health of a business. The cycle measures the average number of days that working capital is invested in the operating cycle. It starts by adding days inventory outstanding (DIO) to days sales outstanding (DSO). This is because a company "invests" its cash to acquire/build inventory, but does not collect cash until the inventory is sold and the accounts receivable are finally collected. Receivables are essentially loans extended to customers that consume working capital; therefore, greater levels of DIO and DSO consume more working capital. However, days payable outstanding (DPO), which essentially represent loans from vendors to the company, are subtracted to help offset working capital needs. In summary, the cash conversion cycle is measured in days and equals DIO + DSO ± DPO:

Here we extracted two lines from Kohl's (a retail department store) most recent income statement and a few lines from their working capital accounts.

Circled in green are the accounts needed to calculate the cash conversion cycle. From the income statement, you need net sales and COGS. From the balance sheet, you need receivables, inventories and payables. Below, we show the two-step calculation. First, we calculate the three turnover ratios: receivables turnover (sales/average receivables), inventory turnover (COGS/average inventory) and payables turnover (purchases/average payables). The turnover ratios divide into an average balance because the numerators (such as sales in the receivables turnover) are flow measures over the entire year. Also, for payables turnover, some use COGS/average payables. That's okay, but it's slightly more accurate to divide average payables into purchases, which equals COGS plus the increase in inventory over the year (inventory at end of year minus inventory at beginning of the year). This is better because payables finance all of the operating dollars spent during the period (that is, they are credit extended to the company). And operating dollars, in addition to COGS, may be spent to increase inventory levels. The turnover ratios do not mean much in isolation; they are used to compare one company to another. But if you divide the turnover ratios into 365 (for example, 365/receivables turnover), you get the "days outstanding" numbers. Below, for example, a receivable turnover of 9.6

becomes 38 days sales outstanding (DSO). This number has more meaning; it means that, on average, Kohl's collects its receivables in 38 days.

Here is a graphic summary of Kohl's cash conversion cycle for 2003. On average, working capital spent 92 days in Kohl's operating cycle:

Let's contrast Kohl's with Limited Brands. Below we perform the same calculations in order to determine the cash conversion cycle for Limited Brands:

While Kohl's cycle is 92 days, Limited Brand's cycle is only 37. Why does this matter? Because working capital must be financed somehow, with either debt or equity, and both companies use debt. Kohl's cost of sales (COGS) is about $6.887 billion per year, or almost $18.9 million per day ($6.887 billion/365 days). Because Kohl's cycle is 92 days, it must finance--that is, fund its working capital needs--to the tune of about $1.7+ billion per year ($18.9 million x 92 days). If interest on its debt is 5%, then the cost of this financing is about $86.8 million ($1.7 billion x 5%) per year. However, if, hypothetically, Kohl's were able to reduce its cash conversion cycle to 37 days--the length of Limited Brands' cycle--its cost of financing would drop to about $35 million ($18.9 million per day x 37 days x 5%) per year. In this way, a reduction in the cash conversion cycle drops directly to the bottom line.

But even better, the year over year trend in the cash conversion cycle often serves as a sign of business health or deterioration. Declining DSO means customers are paying sooner; conversely, increasing DSO could mean the company is using credit to push product. A declining DIO signifies that inventory is moving out rather than "piling up." Finally, some analysts believe that an increasing DPO is a signal of increasing economic leverage in the marketplace. The textbook examples here are Walmart and Dell: these companies can basically dictate the terms of their relationships to their vendors and, in the process, extend their days payable (DPO). Looking "Under the Hood" for Other Items Most of the other working capital accounts are straightforward, especially the current liabilities side of the balance sheet. But you do want to be on the alert for the following:
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Off-balance-sheet financing Derivatives

For examples of these two items, consider the current assets section of Delta Airlines' fiscal year 2003 balance sheet:

Notice that Delta's receivables more than doubled from 2002 to 2003. Is this a dangerous sign of collections problems? Let's take a look at the footnote: We were party to an agreement, as amended, under which we sold a defined pool of our accounts receivable, on a revolving basis, through a special-purpose, wholly owned subsidiary, which then sold an undivided interest in the receivables to a third party.... This agreement terminated on its scheduled expiration date of March 31, 2003. As a result, on April 2, 2003, we paid $250 million, which represented the total amount owed to the third party by the subsidiary, and subsequently collected the related receivables. (Note 8, Delta 10-K FY 2003) Here's the translation: during 2002, most of Delta's receivables were factored in an off-balance sheet transaction. By factored, we mean Delta sold some of its accounts receivables to another company (via a subsidiary) in exchange for cash. In brief, Delta gets paid quickly rather than

having to wait for customers to pay. However, the seller (Delta in this case) typically retains some or all of the credit risk - the risk that customers will not pay. For example, they may collateralize the receivables. We see that during 2003, the factored receivables were put back onto the balance sheet. In economic terms, they never really left but sort of disappeared in 2002. So the 2003 number is generally okay, but there was not a dramatic jump. More importantly, if we were to analyze year 2002, we'd have to be sure to manually "add-back" the off-balance sheet receivables, which would otherwise look artificially favorable for that year. We also highlighted Delta's increase in "prepaid expenses and other" because this innocentlooking account contains the fair value of Delta's fuel hedge derivatives. Here's what the footnote says: Prepaid expenses and other current assets increased by 34%, or $120 million, primarily due to an increase in prepaid aircraft fuel as well as an increase in the fair value of our fuel hedge derivative contracts.... Approximately 65%, 56% and 58% of our aircraft fuel requirements were hedged during 2003, 2002 and 2001, respectively. In February 2004, we settled all of our fuel hedge contracts prior to their scheduled settlement dates« and none of our projected aircraft fuel requirements for 2005 or thereafter.

The rules concerning derivatives are complex, but the idea is this: it is entirely likely that working capital accounts contain embedded derivative instruments. In fact, the basic rule is that, if a derivative is a hedge whose purpose is to mitigate risk (as opposed to a hedge whose purpose is to speculate), then the value of the hedge will impact the carrying value of the hedged asset. For example, if fuel oil is an inventory item for Delta, then derivatives contracts meant to lock-in future fuel oil costs will directly impact the inventory balance. Most derivatives, in fact, are not used to speculate but rather to mitigate risks that the company cannot control. Delta's footnote above has good news and bad news. The good news is that as fuel prices rose, the company made some money on its fuel hedges, which in turn offset the increase in fuel prices - the whole point of their design! But this is overshadowed by news which is entirely bad: Delta settled "all of [their] fuel hedge contracts" and has no hedges in place for 2005 and thereafter! Delta is thus exposed in the case of high fuel prices, which is a serious risk factor for the stock. Summary Traditional analysis of working capital is defensive; it asks, "Can the company meet its shortterm cash obligations?" But working capital accounts also tell you about the operational efficiency of the company. The length of the cash conversion cycle (DSO+DIO-DPO) tells you how much working capital is tied up in ongoing operations. And trends in each of the daysoutstanding numbers may foretell improvements or declines in the health of the business.

Investors should check the inventory costing method, and LIFO is generally preferred to FIFO. However, if the LIFO reserve drops precipitously year over year, then the implied inventory liquidation distorts COGS and probably renders the reported profit margin unusable. Finally, it's wise to check the current accounts for derivatives (or the lack of them, when key risks exist) and off-balance sheet financing.

Conceptual Analysis of Working Capital and its Impact on Profitability
By

Sanjay Kumar Sadana
B.Com (Hons.), M.Com, PGDBA, LL.B (Professional), MBA Finance, PGDPM&IR, M.A.(PM & IR), M.Phil (Finance), PhD (Pursuing)

Principal Guru Gram Business School Faridabad & Gurgaon Campus

Keywords: working capital, rationale, working capital cycle cash nanagement, Baumol, Miller-Orr Model, receivable, trade Credit, factoring, inventory, economic order quantity, JIT, review, literature, purpose, objectives, research, methodology, data, hypothesis, constraints, limitations, conclusions Abstract This working capital paper is a conceptual analysis of working capital and its impact on profitability of an organisation. Working capital is the most crucial asset. Working capital also gives investors an idea of the company's underlying operational efficiency. Comparison has been made between the private sector steel producers and the public sector major steel producers. The objective is to take selective firms representing private sector and public sector and make a comparison. The comparison is on the efficient management of the working capital and its components. We have taken two public sector steel majors and 8 private sector steel players. The aim was to find out the working capital practices prevalent in public sector majors and private sector to make a comparison. To highlight the importance of working capital and its impact on profitability. Working capital is the single best method of determining the position of a company, or how well that company may be doing. Working capital management entails short term decisions - generally, relating to the next one year periods - which are "reversible". Objectives of study and Research methodology helped in proving the research. Despite the constraints and limitations of the study, the Conclusions can help to over come these problems. Highlighted on best possible use of various components of W.C. This is possible if latest techniques of management and cost accounting are used to manage these components. CONCEPTUAL ANALYSIS OF WORKING CAPITAL AND ITS IMPACT ON PROFITABILITY WORKING CAPITAL

Working capital (also known as net working capital) is a financial metric which represents the amount of day-by-day operating liquidity available to a business. "Working Capital" typically means the firm's holdings of current or short-term assets such as cash, receivables, inventory and marketable securities. Along with fixed assets such as plant and equipment, working capital is considered a part of operating capital. It is calculated as current assets minus current liabilities. A company can be endowed with assets and profitability, but short of liquidity, if these assets cannot readily be converted into cash. The working capital ratio is calculated as: WORKING CAPITAL=CURRENT ASSETS ± CURRENT LIABILITIES Positive working capital means that the company is able to pay off its short-term liabilities. Negative working capital means that a company currently is unable to meet its short-term liabilities with its current assets (cash, accounts receivable and inventory). If a company's current assets do not exceed its current liabilities, then it may run into trouble paying back creditors in the short term. The worst-case scenario is bankruptcy. A declining working capital ratio over a longer time period could also be a red flag that warrants further analysis. For example, it could be that the company's sales volumes are decreasing and, as a result, its accounts receivables number continues to get smaller and smaller. Working capital also gives investors an idea of the company's underlying operational efficiency. Money that is tied up in inventory or money that customers still owe to the company cannot be used to pay off any of the company's obligations. So, if a company is not operating in the most efficient manner (slow collection), it will show up as an increase in the working capital. This can be seen by comparing the working capital from one period to another; slow collection may signal an underlying problem in the company's operations. WORKING CAPITAL MANAGEMENT Working capital management involves the relationship between a firm's short-term assets and its short-term liabilities. The goal of working capital management is to ensure that a firm is able to continue its operations and that it has sufficient ability to satisfy both maturing short-term debt and upcoming operational expenses. The management of working capital involves managing inventories, accounts receivable and payable, and cash. Working capital is the single best method of determining the position of a company, or how well that company may be doing. When all is said and done, the company's working capital is what makes it profitable or not profitable. The more working capital a company has the better that company is doing, financially. Many potential investors and others in the public sphere will scrutinize a balance sheet to find the working capital calculation of a company. According to many sources, the working capital calculation is the simplest to perform. Simply subtract the short-term liabilities of a company from the current assets. What you are left with is the working capital of the company. All short-term liabilities must be accounted for, as well as all current assets. This is not as simple as just counting the available cash on hand. The working capital of a company is a requires a vast working

capital calculation to find the exact amount of working capital. That said why is a working capital calculation so important. Knowing the amount of working capital a company has is vital to many aspects. The working capital calculation will tell the company, as well as the investors, exactly how well the company is doing. In addition, the company's working capital constitutes the amount used for purchasing new equipment, new stocks and much more. Working capital is the single most important aspect of a company, whether you are judging performance or speculating on expanding the company. Without the required working capital and knowledge of how to perform a working capital calculation, it may be impossible for a business to grow and prosper. Having the right amount of working capital is the only way in which a company can advance Decisions relating to working capital and short term financing are referred to as working capital management. These involve managing the relationship between a firm's short-term assets and its short-term liabilities. The goal of Working capital management is to ensure that the firm is able to continue its operations and that it has sufficient cash flow to satisfy both maturing short-term debt and upcoming operational expenses. DECISION CRITERIA By definition, working capital management entails short term decisions - generally, relating to the next one year periods - which are "reversible". These decisions are therefore not taken on the same basis as Capital Investment Decisions (NPV or related, as above) rather they will be based on cash flows and / or profitability. One measure of cash flow is provided by the cash conversion cycle - the net number of days from the outlay of cash for raw material to receiving payment from the customer. As a management tool, this metric makes explicit the inter-relatedness of decisions relating to inventories, accounts receivable and payable, and cash. Because this number effectively corresponds to the time that the firm's cash is tied up in operations and unavailable for other activities, management generally aims at a low net count. In this context, the most useful measure of profitability is Return on capital (ROC). The result is shown as a percentage, determined by dividing relevant income for the 12 months by capital employed; Return on equity (ROE) shows this result for the firm's shareholders. Firm value is enhanced when, and if, the return on capital, which results from working capital management, exceeds the cost of capital, which results from capital investment decisions as above. ROC measures are therefore useful as a management tool, in that they link short-term policy with long-term decision making. RATIONALE OF WORKING CAPITAL The definition of working capital is fairly simple, it is the difference between an organisation's current assets and its current liabilities. Of more importance is its function which is primarily to support the day-to-day financial operations of an organisation, including the purchase of stock, the payment of salaries, wages and other business expenses, and the financing of credit sales. As the cycle indicates, working capital comprises a number of different items and its management is difficult since these are often linked. Hence altering one item may impact

adversely upon other areas of the business. For example, a reduction in the level of stock will see a fall in storage costs and reduce the danger of goods becoming obsolete. It will also reduce the level of resources that an organisation has tied up in stock. However, such an action may damage an organisation's relationship with its customers as they are forced to wait for new stock to be delivered, or worse still may result in lost sales as customers go elsewhere. Extending the credit period might attract new customers and lead to an increase in turnover. However, in order to finance this new credit facility an organisation might require a bank overdraft. This might result in the profit arising from additional sales actually being less than the cost of the overdraft. Management must ensure that a business has sufficient working capital. Too little will result in cash flow problems highlighted by an organisation exceeding its agreed overdraft limit, failing to pay suppliers on time, and being unable to claim discounts for prompt payment. In the long run, a business with insufficient working capital will be unable to meet its current obligations and will be forced to cease trading even if it remains profitable on paper. On the other hand, if an organisation ties up too much of its resources in working capital it will earn a lower than expected rate of return on capital employed. Again this is not a desirable situation. The working capital cycle The working capital cycle starts when stock is purchased on credit from suppliers and is sold for cash and credit. When cash is received from debtors it is used to pay suppliers, wages and any other expenses. In general a business will want to minimise the length of its working capital cycle thereby reducing its exposure to liquidity problems. Obviously, the longer that a business holds its stock, and the longer it takes for cash to be collected from credit sales, the greater cash flow difficulties an organisation will face. In managing its working capital a business must therefore consider the following question. 'If goods are received into stock today, on average how long does it take before those goods are sold and the cash received and profit realised from that sale? Guided by the above criteria, management will use a combination of policies and techniques for the management of working capital. These policies aim at managing the current assets (generally cash and cash equivalents, inventories and debtors) and the short term financing, such that cash flows and returns are acceptable. CASH MANAGEMENT Identify the cash balance which allows for the business to meet day to day expenses, but reduces cash holding costs. A firm should hold an optimum balance of cash, and invest any temporary excess amount in short-term (marketable) securities. In choosing these securities, the firm must keep in mind safety, maturity and marketability of its investment. Management of Cash involves three things: a) managing cash flows into and out of the firm b) managing cash flows within the firm

c) financing deficit or investing surplus cash and thus, controlling cash balance at a point of time. It is an important function in practice because it is difficult to predict cash flows and there is hardly any synchronisation between inflows and outflows. Firms prepare cash budget to plan for and control cash flows. Cash budget is generally prepared for short periods such as weekly, monthly, quarterly, half-yearly or yearly. Cash budget will serve its purpose only if the firm can accelerate its collections and postpone its payments within allowed limits. The main concerns in collections are: (a) to obtain payment from customers within the credit period, and (b) to minimise the lag between the time a customer pays the bill and the time cheques etc. are collected. The financial manager should be aware of the instruments of payments, and choose the most convenient and least costly mode of receiving payment. Disbursements or payments can be delayed to solve a firm's working capital problem. But this involves cost that, in the long run, may prove to be highly detrimental. Therefore, a firm should follow the norms of the business. Receipts and Disbursements Method is employed to forecast for shorter periods. The individual items of receipts and payments are identified and analysed. Cash inflows could be categorised as: (i) operating, (ii) non-operating, and (iii) financial. Cash outflows could be categorised as: (i) operating, (ii) capital expenditure, (iii) contractual, and (iv) discretionary. Such categorisation helps in determining avoidable or postponable expenditures. Adjusted Income Method uses proforma income statement (profit and loss statement) and balance sheet to work out cash flows (by deriving proforma cash flow statement). As cash flows are difficult to predict, a financial manager does not base his forecasts only on one set of assumptions. He or she considers possible scenarios and performs a sensitivity analysis. At least, forecasts under optimistic, most probable and pessimistic scenarios can be worked out. Concentration Banking and Lock-Box System methods followed to expedite conversion of an instrument (e.g., cheque, draft, bills, etc.) into cash. The excess amount of cash held by the firm to meet its variable cash requirements and future contingencies should be temporarily invested in marketable securities, which can be regarded as near moneys. A number of marketable securities may be available in the market.The financial manager must decide about the portfolio of marketable securities in which the firm's surplus cash should be invested. One of the primary responsibilities of the financial manager is to maintain a sound liquidity position of the firm so that the dues are settled in time. A firm maintains operating cash balance for transaction purpose. The amount of cash balance is dependent on the riskreturn trade-off. If a firm maintains small cash balance, its liquidity position weakens, but its profitability improves as the released fund can be invested in profitable opportunities. On the other hand, if the firm high cash balance, it will have a strong liquidity position but its profitability will be low. Thus to determine optimum cash balance two models are available. These are: Baumol Model Baumol Model of Cash Management considers cash management similar to an inventory management problem. The formula is

where C* is the optimum cash balance, c is the cost per transaction, T is the total cash needed during the year and k is the opportunity cost of holding cash balance. The optimum cash balance will increase with increase in the per transaction cost and total funds required and decrease with the opportunity cost. Miller-Orr Model Miller-Orr Model saysIf the firm's cash flows fluctuate randomly and hit the upper limit, then it buys sufficient marketable securities to come back to a normal level of cash balance (the return point). Similarly, when the firm's cash flows wander and hit the lower limit, it sells sufficient marketable securities to bring the cash balance back to the normal level (the return point). The formula for determining the distance between upper and lower control limits (called Z) is as follows:

RECEIVABLE MANAGEMENT Identify the appropriate credit policy, i.e. credit terms which will attract customers, such that any impact on cash flows and the cash conversion cycle will be offset by increased revenue and hence Return on Capital (or vice versa). Trade Credit arises when a firm sells its product or services on credit and does not receive cash immediately. It creates debtors (book debts) or accounts receivable. It is used as a marketing tool to maintain or expand the firm's sales. A firm's investment in accounts receivable depends on volume of credit sales and collection period. Credit Policy The financial manager can influence volume of credit sales and collection period through credit policy. Credit policy includes credit standards, credit terms, and collection efforts. The incremental return that a firm may gain by changing its credit policy should be compared with the cost of funds invested in receivables. The firm's credit policy will be considered optimum at the point where incremental rate of return equals the cost of funds. The cost of funds is related to risk; it increases with risk. Thus, the goal of credit policy is to maximise the shareholders wealth; it is neither maximisation of sales nor minimisation of bad-debt losses. Credit Standards are criteria to decide to whom credit sales can be made and how much. If the firm has soft standards and sells to almost all customers, its sales may increase but its costs in the form of bad-debt losses and credit administration will also increase. Therefore, the firm will have to consider the impact in terms of increase in profits and increase in costs of a change in credit standards or any other policy variable. Credit Terms The conditions for extending credit sales are called credit terms and they include the credit period and cash discount.

Cash Discounts are given for receiving payments before than the normal credit period. All customers do not pay within the credit period. Therefore, a firm has to make efforts to collect payments from customers. Collection Efforts of the firm aim at accelerating collections from slow-payers and reducing bad-debt losses. The firm should in fact thoroughly investigate each account before extending credit. It should gather information about each customer, analyse it and then determine the credit limit. Depending on the financial condition and past experience with a customer, the firm should decide about its collection tactics and procedures. Average Collection Period and Aging Schedule are methods to monitor receivables. They are based on aggregate data for showing the payment patterns, and therefore, do not provide meaningful information for controlling receivables. Collection Experience Matrix Receivables outstanding for a period are related to credit sales of the same period. This approach is better than the two traditional methods of monitoring receivables. Factoring involves sale of receivables to specialised firms, called factors. Factors collect receivables and also advance cash against receivables to solve the client firms' liquidity problem. They charge commission for providing their services and interest on advance. INVENTORY MANAGEMENT Identify the level of inventory which allows for uninterrupted production but reduces the investment in raw materials - and minimizes reordering costs - and hence increases cash flow. Inventory is a list for goods and materials, or those goods and materials themselves, held available in stock by a business. Inventory are held in order to manage and hide from the customer the fact that manufacture/supply delay is longer than delivery delay, and also to ease the effect of imperfections in the manufacturing process that lower production efficiencies if production capacity stands idle for lack of materials. There are three basic reasons for keeping an inventory: a. Time - The time lags present in the supply chain, from supplier to user at every stage, requires that you maintain certain amount of inventory to use in this "lead time" b. Uncertainty - Inventories are maintained as buffers to meet uncertainties in demand, supply and movements of goods. c. Economies of scale - Ideal condition of "one unit at a time at a place where user needs it, when he needs it" principle tends to incur lots of costs in terms of logistics. So Bulk buying, movement and storing brings in economies of scale, thus inventory. Economic Order Quantity (EOQ) One of the major inventory management problems to be resolved is how much inventory should be added when inventory is replenished. These problems are called order quantity problems, and the task is to determine the optimum or economic odder quantity (EOQ). Determining this EOQ involves two types of costs:

Ordering Costs is the cost incurred for requisition, placing of order, transportation, receiving, inspecting and storing and clerical and staff services. Ordering costs are fixed per order. Therefore, they decline as the order size increases. Carrying Costs is the cost incurred for warehousing, handling, clerical and staff services, insurance and taxes. Carrying costs vary with inventory holding. As order size increases, average inventory holding increases and therefore, the carrying costs increase. The firm should minimise the total cost (ordering plus carrying). The economic order quantity (EOQ) of inventory will occur at a point where the total cost is minimum. The following formula can be used to determine EOQ:

where A is the annual requirement, O is the per order cost, and c is the per unit carrying cost. The economic order level of inventory, Q*, represents maximum operating profit, but it is not optimum inventory policy.

Figure:1.1 Optimum Inventory Policy: The value of the firm will be maximised when the marginal rate of return of investment in inventory is equal to the marginal cost of funds. The marginal rate of return (r) is calculated by dividing the incremental operating profit by the incremental investment in inventories, and the cost of funds is the required rate of return of suppliers of funds. Reorder Point: The inventory level at which the firm places order to replenish inventory is called the reorder point. It depends on (a) the lead time and (b) the usage rate. Under perfect certainty about the usage rate, and instantaneous delivery (i.e., zero lead time), the reorder point will be equal to: Lead time x Usage rate. Safety Stock: In practice, there is uncertainty about the lead time and/or usage rate. Therefore, firms maintain safety stock which serves as a buffer or cushion to meet contingencies. In that case, the reorder point will be equal to:

Lead time × Usage rate + Safety stock The firm should strike a trade-off between the marginal rate of return and marginal cost of funds to determine the level of safety stock. Inventory Control System A firm needs an inventory control system to effectively manage its inventory. There are several inventory control systems in practice. They range from simple systems to very complicated systems. The nature of the business & the size dictates the choice of an inventory control system. Some of these systems are: A-B-C Analysis A-B-C Analysis A firm, which carries a number of items in inventory that differ in value, can follow a selective control system. A selective control system, such as the A-B-C analysis, classifies inventories into three categories according to the value of items: A-category consists of highest value items, B-category consists of high value items and C-category consists of lowest value items. More categories of inventories can also be created. Tight control may be applied for high-value items and relatively loose control for low value items. Just-In±Time (JIT) System Japanese firms popularized the Just-In-Time (JIT) system. In a JIT system materials or manufactured components & parts arrive to the manufacturing sites or stores just few hours before put to use. The delivery of material is synchronized with the manufacturing cycle & speed. JIT system eliminates the necessity if carrying large inventory and thus saves carrying 7 other related costs. The system requires perfect understanding & coordination between manufacturer & supplier in terms of timing of delivery & quality of material. NEED OF STUDY "Working Capital" typically means the firm's holdings of current or short-term assets such as cash, receivables, inventory and marketable securities. Much academic literature is directed towards gross working capital i.e. total current or circulating assets. These items are referred to as "circulating assets" because of their cyclical nature. In retail establishment, cash is initially employed to purchase inventory, which in turn sold on credit and results in accounts receivables. Once the receivables are collected, they become cash ± part of which is reinvested in additional inventory and part (i.e., the amount above cost) goes to profit or cash throw-off. Financial managers devote a considerable amount of attention to the management of working capital. Net working capital (current assets minus current liabilities) provides an accurate assessment of the liquidity position of the firm. With the liquidity-profitability dilemma solidly authenticated in the financial scheme of management, concentrated efforts are made to ensure the ability of the firm to meet those obligations, which mature within a twelve months period. Management must always ensure the solvency and visibility of the firm. An examination of the components of working capital is helpful because of the preoccupation of management with the proper combination of assets and acquired funds.

Short-term or current liabilities constitute the portion of funds, which have been planned for and raised. Since management must be concerned with proper financial structure, these and other funds must be raised judiciously. Short-term or current assets constitute a part of the asset-investment decision and require diligent review by the firm's executives. REVIEW OF EXISTING LITERATURE Though a considerable amount of work has already been done on the above mentioned subject. Efficient working capital management still holds the key to profitability in organizations. Scientific working capital management and efficacy in managing the components of working capital can give an impetus to the profits of an organization. Much research has still to be done as this is a very important area of financial management. It is an inter disciplinary area and practically can be implemented in consultation with various kinds of professional from diverse fields like finance, materials, production, etc. In our present study we have made a attempt to gauge the impact of efficient working capital management in the context of Steel Industry. We have also tried to make a comparison between working capital management of public sector and private sector Steel organizations and their impact on the earning capacity (Profitability ) of the organization. Purpose/ Objectives of Study * To gain familiarity with the various components of working capital in Steel Industry. * To make a comparative study in the efficacy of working capital management between private sector units like: TISCO, Jindal Steel, Essar Steel, Ispat, MUSCO, Sunflag etc., and public sector undertaking SAIL (Steel Authority of India Limited) and its various units. * To judge the success of the management in carrying on the daily transactions of the Industry. * To gain an in-depth knowledge of the tricks of managing the daily financial activities of the Steel Industry. * To find out the difference between the theoretical and practical aspect of working capital management. * To study and come out with any solution for improvement of working capital management at Steel Industry. Detailed Objectives of the Study The main objective of the present work is to make a study on the efficiency in the management of short-term liquidity in selected public and private sector Iron and Steel enterprises in India. More specifically, the objectives of the present study in general are:1. To assess the management of working capital. To study the optimum level of current assets and current liabilities of the 2. company. 3. To Study the Operating Cycle of the Company.

4. To examine the Influence of determinants of working capital. 5. Estimation of working capital requirements. 6. To know how the working capital needs are fulfilled? 7. To study the way and means of working capital finance 8. To examine the adequacy or otherwise of the working capital; 9. To analyze working capital management from different analysis on the basis of historical data. 10. To observe the liquidity position and areas of weakness, if any 11. To give suggestions for removal of the weaknesses. 12. To study the following components/aspects that includes in the working capital * Cash management * Receivable management * Inventory management RESEARCH METHODOLOGY "Research methodology is a way to systematically solve the research problem" "It is a procedure, which is followed step by step to solve a particular research problem." It is important for research to know not only the research method but also know methodology. "The procedures by which researcher go about their work of describing, explaining and predicting phenomenon are called methodology." Methods comprise the procedures used for generating, collecting and evaluating data. All this means that it is necessary for the researcher to design his methodology for his problem as the same may differ from problem to problem. Data collection is important step in any project and success of any project will be largely depend upon now much accurate you will be able to collect and how much time, money and effort will be required to collect that necessary data, this is also important step. Data collection plays an important role in research work. Without proper data available for analysis you cannot do the research work accurately. Methodology of the Study Companies Covered We select for our study two out of nine Central Public Sector Iron and Steel Enterprises operating in India. These two public sector enterprises are:1. Steel Authority of India Limited (SAIL, consolidation of all steel plants including subsidiary company, IISCO and MEL, which are again considered as separate units), 2. Indian Iron and Steel Company Ltd. (IISCO, which is a wholly-owned subsidiary of SAIL). The private sector enterprises covered in the analyses are:TISCO, Jindal Steel, Essar Steel, ISPAT, MUSCO, Sunflag, Surya Roshni (Surya Global Ltd.) Period of the Study

The study covers a period of 7 years from 2003 to 2009 (both years inclusive). The reasons for confining the study to this period are: (1) liberalisation policy was adopted in India on 21st July, 1991, and (2) the availability of the latest audited data in the government publications. Nature of data used The study is based on the secondary data obtained from the audited balance sheets and profit & loss accounts and also the annual reports of the Public Enterprises Survey, Ministry of Heavy Industries & Public Enterprises, New Delhi. Besides, the facts, figures and findings advanced in similar earlier studies and the government publications are also used to supplement the secondary data. The data which I have collected for making this Thesis is combination of both primary and secondary data. PRIMARY DATA: This data had been collected through meetings and interviews with various managers and employees of the finance department of various private and public sector Steel Units. At the same time I had visited various departments for collection of data. The departments that had been visited are as follows:y y y y y y y y Main Cash Department Billing and Operation Department Budget Department Pay Section Excise Department. Welfare & Miscellaneous Bill Section Sales Department Project Management Department

SECONDARY DATA: Apart from the primary data certain secondary data were required for this project. Following are the sources of secondary data:y y y y y y y y y Annual Reports Cost & Budget Reports Cash Report Raw Materials Report Production Reports Creditors Reports Debtors Reports Inventory Reports Sales Reports

The Paper titled "Impact of Working Capital Management on Profitability with Special reference to Steel Industry" required a comparative analysis of working capital patterns followed in various steel plants of Private & Public Sector Organizations.

Personal visits to private sector steel organizations viz, Jindal Steel, TISCO, Essar Steel, ISPAT, MUSCO, Sunflag, Surya Roshni etc. was made to collect the relevant data / annual reports for the purpose of analysis of working capital. The following integrated steel plants of SAIL have been considered for comparative analysis of their working capital:y y y y Durgapur Steel Plant(DSP) Bhilai Steel Plant(BSP) Rourkela Steel Plant(RSP) Bokaro Steel Plant(BSL)

This study will assist to evaluate the efficiency of working capital management practices in these plants and also analyze the working capital practices followed by Private sector steel producers and Public sector steel producers. This in-depth analysis will help the management of the companies to reduce the unnecessary blockage of funds and make the best possible use of the available funds. Here in this study, working capitals of the plants both in public sector as well as private sector have been calculated sequentially and an effort has been made to indentify the trend of working capital in the past seven years by analyzing the components of working capital. In addition to this, certain ratios have been derived to give a better picture of the efficiency of the management in dealing with working capital in these plants. The analysis of plants is based only on financial data provided in the balance sheet. But working capital analysis also needs some non-financial details. Data of seven consecutive years starting from the year 2002-03 of the above steel plants have been included for comparative study. Financial figures of the last year have not been taken for study because it is under audit and not available for use. TYPES OF RESEARCH Basically there are four types of research: 1. 2. 3. 4. Exploratory Research Descriptive Research Diagnostic Research Hypothesis Testing Research

EXPLORATORY RESEARCH To gain familiarity with a phenomenon or to achieve insight into it. DESCRIPTIVE RESEARCH To portray accurately the characteristics of an individual, situation or a group. DIAGNOSTIC RESEARCH To determine the frequency with which something, occurs or with which it is with something else. associated

HYPOTHESIS TESTING RESEARCH To test a hypothesis of casual relationship between variables. The present project report is descriptive in nature. It is done to portly accurately the characteristics of a particular individual Situation. RESEARCH HYPOTHESIS 1. A Null Hypothesis Ho a setup. This is a conservative statement about the population parameter, and it is term because it almost invariably states that the given samples is derived from a population which is better or no worse than some standard population or that no change has occurred. 2. On the assumption that the Null Hypothesis is correct the probability of a given samples statistics is calculated. 3. If the probability P in (2) is more than the chosen level of tolerable risk for type one error, the Null Hypothesis is accepted stating that there is insufficient evidence to reject the null hypothesis at a given level of significance. This means that it is not reasonable to obtain such a representative sample from the null population at a given level of significance. 4. If the probability P in (2) above is less than the chosen level of significance, the Null Hypothesis is rejected saying that it has been shown beyond reasonable doubt that such a sample is not expected of the null population at a given level of significance. Hence, the Alternate Hypothesis is accepted. DEVELOPMENT OF HYPOTHESIS IN THE PRESENT STUDY The hypothesis to be tested by various analytical tools:1. That efficient working capital management and efficacy in the use of various components of working capital have a determining effect on the profitability of any organization. In the present case our study has been restricted to the steel industry in specific. 2. Our study has been based on a few public sector steel organizations and a few private sector steel organizations. 3. a comparison has been tried to be made between the working capital management of public sector steel organizations and private sector steel organization. The alternate hypothesis is that efficient working capital management and efficacy in the use of various components have no effect on the profitability of the organization in particular steel organizations. Scope of the study The scope of the study is identified after and during the study is conducted. Appropriate Financial / Statistical tools have been used wherever possible for the purpose of analysis. The study of working capital is based on tools like trend Analysis, Ratio Analysis, working capital leverage, operating cycle etc. Further the study is based on previous 7 years Annual Reports of the Public sector and Private sector steel organizations.

CONSTRAINTS / LIMITATIONS OF THE STUDY. y y y y Availability of data ( financial Data) is major constraint Availability of primary data is another constraint Reliance has been given to secondary data available from various credible sources like: government publications, ministry of commerce and industry etc. Attempt has been made to visit offices of steel companies and collect information / interact with officials wherever possible. It was seen that the private steel players were not very keen to divulge details / information pertaining to sensitive matters like: current assets, current liabilities especially cash, loans & inventory. A very important and current topic. Efficient management of working capital becomes all the more important under inflationary conditions. We have to use the latest and best techniques to manage the various components of working capital be it a) Inventory Management b) Receivables Management c) Cash Management y y It is subjective and controversial topics which is very current in the modern management. The subject of the thesis is not amenable to statistical hypothesis testing. Though and honest attempt has been made to be as analytical as possible and make use of the analytical tools.

y y

Following Conclusions can help to over come these problems. y y y y y Cash management should not be fully centralized. A proportion of profit should be there with the units as Reserve & Surplus. In Inventory management the units should use advance techniques as much as possible. Ordering cost is fixed. Thus the unit should fix the amount of delivery at a point that minimizes total transportation cost & carrying cost. There should be proper shed to keep all raw materials. Otherwise these materials can be damaged in rain & heat of sun.

More detailed study of operations is required to understand problems with inventory conversion period & inventory turnover. Highlighted on best possible use of various components of W.C.This is possible if latest techniques of management and cost accounting are used to manage these components.