working capital management: policies and practices ...

WORKING CAPITAL MANAGEMENT: POLICIES AND PRACTICES IN SRI LANKA I. M. Pandey J.P. Gupta K.L.W. Perera

Abstract

II he study

provides an empirical evidence of the Working Capital Management (WCM) policy and practices of the private sector manufacturing companies in Sri Lanka. It is observed that the CEO plays an important role in formulating the WCM policy. However, a number of Sri Lankan companies have informal WCM policy. Company size influences the types or approaches (formal or informal; conservative, moderate or agressive) of overall WCM policy. While Materia.ls Requirement Planning (MRP) ond Perpetual Inventory Control (PIC) systems are the key techniq es of managing inventory, stretching of credit payment and ageing schedule are the primary tools of managing disbursement float and controlling accounts receivable, respectively . Moreover, current ratio and cash budget are the most frequently used WC planning and control techniques. A number of similarities could be found in the WCM policy and practices between companies in Sri Lanka and the USA . The only difference observed is 1n terms of the use of computerized system and the ?pportunity to invest surplus fund tn the money market instruments.

About the Authors INDRA M. PANDEY is a full - time Professor of Finance at the Indian Institute of Management, Ahmedabad (liMA), India . He has been connected with liMA since 1984. Prior to 1984, he served as a professor in several institutes in India, namely, National Institute of Bank Management, Xavier's Institute of Management and Labour Relations, Indian Institute of Technology and Shri Ram College of Commerce. Prof. Pandey has been a Visiting Faculty at the Asian Institute of Technology in Thailand , Paris Graduate School of Business in France, University of Birmingham, U.K ., Kansas Stale University, USA and Graduate School of Business, ESSEC , France . He has authored 1 0 books, w ritten 50 articles and management cases, all published in internationally - referred journals . JYOTI PRAKASH GUPTA is currently the Dean of the School of Management at the Asian Institute of Technology. He is seconded by the French Government and leaches permanently at the Paris Graduate School of Management where he is a Professor of Finance . Prof . Gupta graduated from the Indian Institute of Technology and Engineering and completed his Ph.D. from the University of Manchester. He has taught as a Visiting Profes sor in several universities in Europe, America and Japan . Before taking up teaching activities , he has worked in senior management with multinati onal corr; Panies . He is the author of publications and academic articles in the f1eld of corporate finan c e theory and the capital marketing activities of banks and financial instituti ons He has done extensi v e consulting activities with the corporate firms and financial institutions .

K.L.W. PERERA is currently a lectrurer in the Deportment of Commerce at the Univ ersity of Sri Jw ayewordenepura, Negegoda , Sri Lanka . He obtained his MBA degree from the School of Management at the Asian Institute of Technology, Bangkok, Thailand .

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INTRODUCTION Working capital management has not been accorded sufficient attention in much of the finance literature. Some experts imply that high business failures occur due to poor corporate decisions made in the area of working capital management [1]. Researchers also think that the theories of working capital are not amenable to practical application [2]. Therefore, this field of research academically remained neglected until the sixties [3]. Dramatic developments took place only in the early seventies [4] when its practical use was first fully realized. Theorists in the field feel that the management of short-term assets and liabilities is more important than long-term investments in manufacturing companies [5]. Current assets do form a large proportion of total assets in both developed and developing countries. For example in the USA, current assets are about onethird of the total corporate assets where the practice of working capital management has reached a high level of sophistication. These practices in the developed countries are well documented [6], unfortunately, evidence on working capital management practices in developing countries is scanty [7]. It is under this scenario that this paper is presented. Specifically, it opts to document the working capital management policies and practices of manufacturing companies in Sri Lanka. Manufacturing companies play a major role in the economic development of Sri Lanka. During the last two decades, the manufacturing sector in the country has made significant contributions to the national income particularly in its exports. In spite of their contribution however, the sector remains in its developing stage. Most of the manufacturing companies need short- and long-term funds for expansion. But since the capital markets in Sri Lanka are still in the nascent stage compared with the markets of developed countries, the - flow of additional capital is rather slow. Managing available capital is, thus, a challenge in the country. The optimum utilization of existing capital remains essential for sustaining and expanding the operations of most companies in the country.

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This paper presents the results of a survey of working capital management practices and policies of listed manufacturing companies in Sri Lanka . It focuses on the : (a) overall working capital management policies , (b) management of working capital components, and (c) working capital planning and control. A comparison of practices is also made with companies in the same sector in the USA.

RESEARCH AND METHODOLOGY The sample of compa nies was selected from the Colombo Stock Exchange (CSE) . In 1995, eighty manufacturing and processing companies were registered in the CSE. Out of these, a sample of fifty was randomly selected for the study . Data were collected through a questionnaire following the format used by Smith and Shirley (1978) in their study of American firms but was modified according to the Sri Lankan business environment. The questionna ire included both open - ended and multiple-choice questions . Forty companies responded and after rejecting four, the response rate is put at 45%. Thus, the results are based on data from thirty - six companies . It may be noticed that the response rate for individual questions differs since not all of the questions were responded to by every company . Table 1. Distribution of Sam

Size and Profitabili

Criteria Size(sales): Small

No. 25

< Rs. 200 000

50

,000 and < Rs. 1 ,000,000

25

Lor e Total sam le

100

36

Profitability (ROE): Low

< 5%

Medium

> 5% and < 10%

High

10% and above Total sample

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22

8

22

20

56 36

100

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77

Existing literature on the subject area reveal that size and profitability are important variables influencing working capital management practices [8]. Therefore, the results of this study are also analyzed relevant to company size and profitability. Size is measured in terms of rupee sales and profitability in terms of return on equity (ROE) . Half of the respondents are medium-sized companies and more than half maintains 10% or more ROE (Table 1).

SURVEY RESULTS

Working Capital Management Policy This section explores answers to the following questions: (a) Do Sri Lankan companies have explicit or implicit policies for working capital? (b) Who is responsibie for formulating the policies (c) Who reviews the working capital policy? (d) What are the methods of estimation of working capital needs? (e) In practice, what are the specific working capital policies of particular companies?

Overall Policy. In practice, companies follow explicitly stated formal working capital policies or none at all. Most Sri Lankan manufacturing companies follow informal policies. 23 (63.9%) out of 36 responding firms have informal working capital management policies; nine (25%) have formal policies, the remaining four ( 11 %) do not follow any implicit or explicit policies. Thus, about 90% (32) of the respondents follow either formal or informal working capital policies.

Is there any association between the working capital policy, on the one hand and company size and profitability, on the other hand? Table 2 shows these relationships . A significantly greater number of large-sized companies have formal policies for working capital than medium- and small-sized companies. Six out of nine companies following formal policies are large and three are mediumsized. Seven small-sized companies practice informal policies and two follow none at all. Thirteen medium-sized

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companies follow informal policies. Most large-sized companies practice formal policies while medium- and small-sized companies follow either informal or no policy at all. Thus, many of the smallor medium-sized companies in Sri Lanka perhaps do not consider it necessary to have formal working capital management policies . Table 2. Overall Workin Policy

Total Sample Lar e 9 1 23

6

Profitability

3

1 6

3 2 5

9

3

2

6

2

1

1

1--

11

2

14

6 32

Low

3

7

Changes over time

Company Size Medium

16 0.01291

4

3

7

18

c=JL 7

7

0.84474

Survey results do not seem to show a strong association between working capital policies and company profitability. More than half (55%) of the high-profit-earning firms have informal working capital policies and seven out of nine following formal policies are observed to be maintaining high profit margins. Overall, there is no significant relationship between profitability and overall working capital policies . In theory, companies may also have different attitudinal approaches towards the overall working capital management. They may follow conservative, moderate or aggressive approaches. What are the experiences of Sri Lankan companies? Sixteen (50%) of the 32 companies use modera!e policies and seven (21.9%) follow conservative policies . Only three companies follow aggressive approaches. Six (18.8%) companies do not follow any specific approach and adapt their policies depending on the situation. The conservative or moderate working capital approach followed by

Journal of Euro-A..Ian Managomont

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most Sri Lankan manufacturing companies implies a low-risk attitude. Moreover, it may also be said that there is not much flexibility in working capital management in practice. Only six companies in the survey reviews/revises their respective approaches over time. Results also show a relationship between company size and specific policy behaviors (Table 2). Most small-sized companies practice conservative policies and half of them change their policies over a period of time. This shows the low risk attitude of small-sized companies while large-sized companies follow relatively aggressive working capital policies. Most medium-sized manufacturing companies practice moderate policies. This implies that these companies are neither aggressive like large-sized companies nor are they conservative like small-sized companies. They attempt to keep working capital risks and liquidity in balance. There is no significant relationship between working capital policy behaviors and company profitability. It is, however, noticeable that more than half of the high-profit-earning companies practice moderate policies for working capital management in Sri Lanka.

Formulation of Policy. In the Sri Lankan manufacturing sector, the managing director plays a major role in setting the overall, formal or informal, working capital policies ( 15 companies). The second most important responsible executive is the finance manager or controller (9 companies). The board of directors is also involved in setting the overall policies in a few cases (4 companies). In three companies, management committees, generally represented by directors, managing directors, finance managers or controllers and functional managers like sales, production, credit or purchasing, are responsible for formulating the policies. In one company, there is no specific person responsible to draft such policies; depending on the situation, a particular taff sets the overall working capital policy.

Review of Policy. There exists some variation with regard to the periodicity of review of policies. Eleven companies (34.4%) rev1ew

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Working Capital Management: Policies and Practices In Sri Lanka

their respective policies monthly . Quarterly and annual reviews of policies are practiced respectively in six and five companies. Ten companies (31 .3%) do not have fixed schedules for review. They only review the policies when needed. Do the review practices relate to company size and

profitability? More than two-thirds of small-sized companies do not regularly review their working capital policies (except two small sized companies that subject their policies to quarterly review). This is a consistent behavior since most small-sized companies also do not have formal working capital policies. Large- and medium-sized companies use monthly review techniques. Majority of the highprofit-earning firms practice monthly reviews and low-profit-earning firms do not havE: fixed review schedules. This means that lowprofit-earning companies are lax in the review of their working capital perhaps because they have a low-risk attitude compared with large-sized companies . Statistically, a strong relationship between the working capital review practices and company size or profitability do not exist .

Estimation of Working Capital Need. How do manufacturing companies in Sri Lanka estimate their working capital needs? More than half (20 companies) of 35 companies that responded to this question use the current -assets-holding-period for estimating their working capital requirements, while eleven companies (31%) use the working - capital -to-sales ratio. The remaining four employ different estimation techniques, to wit: (a) production capacity and borrowing ability (textile and footwear company); (b) level of stock and debtors (food and beverage company); (c) combination of above methods (industrial product company); and (d) cosh-in hand position (food and beverage company). Results do not show a significant relationship in the working capital estimation techniques and company size and/or profitability . However, it may be noted .that most of the large- and medium-sized companies use the current-assets - holding-period while small-sized companies use the sales ratio. Thirty-one (88.6%) of 35 respondents use both methods to calculate working capital requirements. However, there rs no statistically significant

Jeurnal of Euro-Aslan Management

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association between firm size and working capital estimation technique. Furthermore, about two-thirds of the high-profit-earning firms (63%) use the current-assets-holding-period. Similarly, a large number of companies (60.9%) that follow informal policies also use current- assets-holding-period.

Management of Working Capital Components. This section documents the Sri Lankan companies' practices vis-a-vis the management of working capital components: cash, receivables, inventory and shortterm financing methods like accounts payables and bank finances. Who are the persons responsible for managing the components of working capital? In most Sri Lankan manufacturing companies in the survey, the management of cash, accounts payable and short-term loans are the prime responsibility of the chief financial officer (financial controller or manager) and in some companies, the managing director. The responsibility for managing accounts receivable and inventory is delegated to various company executives.

Cash Management. Collection and disbursement of cash is the most critical aspect of cash management. Most often, the responsibility falls within the domain of the finance manager or controller (32 out of 36 respondent companies). A large majority use written or verbal requests for reducing negative floats (deposit float). Cash discount comes as the second and regional banking as the third most important technique. As opposed to practices in Western countries, the lock-box technique is not important for collection in Sri Lanka. Three companies use "motivation price", combination of cash discounts and requests (written and verbal), and control over future sales for managing and immediately collecting cash from customers. For increasing positive floats (disbursement float), stretching of credit is the most frequently used technique in the country. Thirtyfour companies use this technique and a very large number of them (94.1 %) rank it at first or second place. Centralization of disbursement is the second most important technique. Out of 31

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companies using this technique, Nine companies use bank drafts most important technique for companies follow a combination

28 rank it at first or second place. for their payrolls, which is the third increasing positive floats. Three of all these techniques.

What techniques are used for improving the internal flow of funds within a firm? Companies use several techniques individually or in combination for this purpose . Depository transfer cheque is the most frequently used and all of the eighteen companies using this technique rank it either at first or second place. Wire transfer is the second important mechanism ; 14 of the 16 respondents (87.5%) rank it at first or second place. Regular mail and professional couriers are used as third and fourth most important techniques for transferring funds .

Accounts Receivable Management. Why do firms grant credit to their

customers? Marketing together with competitive conditions is the most frequently used reason. Twenty-seven out of 34 companies (79.4%) give the highest rank to this variable . Industry or trade norms and bad debt losses appear as the second and the third most important factors. Client bargaining power, potential implication of the inventory requirement, existing production capacity, and degree of operating leverage are other factors responsible for granting credit . Most of the manufacturing companies investigate the characteristics (four C's) of customers, viz ., character, capacity, capital and condition when granting credit to them . Twenty-seven out of 31 respondents (8 7. 1 %) consider these characteristics as more important than the formal credit appraisal. Credit scoring is used by 10 firms and sequential credit analysis by 12 firms. Nine companies require bank guarantees and customer deposits for granting credits to customers. How do companies monitor the

payment behavior of customers that have been granted credit? Ageing schedule is mentioned ·as the most important measure . Thirty-three companies use this technique and twenty-six of them (78.8%) rank it at first place. Collection period is the second most important monitoring technique and accounts receivable turnover is the third method . Collection ex perience matrix is theoretically

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considered as a superior method of monitoring receivables [9]. However, this method is given a low importance by most Sri Lankan manufacturing companies .

What criteria are used for evaluating the changes in credit terms? A large number of responding companies (31) consider the effect on the firm's sales as the most important criterion. The effect on the level of the firm's profit is the second most important factor, with 21 out of 29 respondents giving it first or second rank. The effect on the level of accounts receivable and on return on investment (ROI) are third and fourth most important criteria . Inventory Control and Management. The finance manager plays a major role in inventory management in about one-third of the Sri Lankan manufacturing companies . Management committee comes next for this task. Managing directors or other managers such as store managers, account assistants, production managers, general managers and profit center managers are also responsible for managing inventory in some companies. Control Techniques. What techniques are used by Sri Lankan firms in controlling inventory? Fifteen out of 35 responding firms follow the Perpetual Inventory Control (PIC) system . Inventory turnover is the second important technique with 13 firms (37 .1%) following this method. ABC analysis is used by six companies ( 17%) . Results do not indicate a significant relationship between inventory control techniques and company size, profitability, overall working capital policies and approach (Table 3). The two most popular techniques, ABC analysis and PIC system, are used by firms regardless of the differences in size, profitability and type of working capital policies. However, it is revealed that out of the six companies using ABC analysis technique, two are large-sized and four are medium- sized while five are high-profit-earning companies and one maintains a low-profit margin.

Replenishment of Inventory . Several techniques are used by companies for deciding the replenishment and purchase of inventory. However, a large number of them (21 out of 36) use the

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Material Requirement Planning (MRP) technique. Four companies follow inventory guidelines and the Economic Order Quantity (EOQ) technique . Ad - hoc decisions for inventory management is employed by three firms (8 .3%) . The other remaining companies (four) use miscellaneous methods such as stock turnover ratio, company sales, combination of MRP and other techniques to decide the appropriate quantity of inventory to replenish. The relationships between the techniques for replenishing inventory and the company size, profitability, overall policy and specific policy of working capital are summarized in Table 3 . •

Large-sized companies follow the MRP, EOQ and other established techniques. They do not go by the industry guidelines or ad-hoc decisions. Medium- and small-sized companies however, follow established techniques while some go by industry guidelines and ad hoc decisions.

•

A number of high-profit - earning firms follow the MRP technique ( 12 out of 20 respondents); though, others use the EOQ technique, industry guidelines and ad - hoc decisions. This is similar with the case of the moderate - profit-earning firms. However, among the lowprofit-earning firms, a few follow the MRP technique, the rest, the industry guidelines or ad-hoc decisions.

•

Companies with formal working capital management policies do not seem to follow industry guidelines or ad-hoc decisions for inventory replenishment, whereas, companies with informal policies follow all sorts of techniques.

•

Most of the companies with an aggressive or a conservative working capital approach use the MRP technique. But companies with a moderate approach use the inventory replenishment and control method.

Overall, majority of the firms follow the MRP technique for inventory replenishment regardless of the differences 1n s1ze, profitability or the nature of working capital policies.


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Technique Replenish-ment

...

..c:a !. .. 0

I

3

Industry guidelines

I

4

EOQ

I

4

Other

r-4-l

Tota l responses

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3

i'r jD•

3

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ct

iil (")

6

g.

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::l.

ABC analysis

II

6

0

PIC system

ii"

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I

Total respons

:a

Siginificance

II

::J

Ill CQ

Policy

Significance

Ill

II

II

Specific

36

13

:a

Overal l Policy

21

I

c

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0

Profitability

I

Ad-hoc dec is ions

MRP

Company Size

3

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What factors do companies consider while purchasing inventory and what is their importance? Availability of components and materials is the most important variable in the inventory purchases of most Sri Lankan companies. Sixteen out of twenty-five companies (64%) give first rank to this factor . Shortage-cost is the second most important factor, with 19 out of 31 companies (38.5%) rating it at first or the second place . Price discounts and credit terms of suppliers are ranked as the third and the forth important factors . Five companies consider other variables such as : quality and reliability of products (a food and beverage company), annual budget (a ceramic company), continuity of production (a footwear company), economy of purchases (a footwear company), and market demand for products (a food and beverage company) . What factors are considered by the Sri Lankan companies for replenishment of inventory produced in-house? Production schedule is the most important variable. Twenty out of 33 (60.6%) respondents rank it at first place. Seasonality of demand is the second most important factor. Inflationary effect and shortage-cost are not considered as first - priority factors by any company. One company considers necessity of the item as a deciding factor.

Inventory Policy Changes. Companies use multiple criteria for evaluating changes in the inventory policy. Thirty-two firms consider the effect on the firm's profit as the most important criterion although, with varying degrees of emphasis. Thirty-one firms think the effect on level of investment is an important factor. Effect on ROI (28 respondents) and effect of inventory cost (27 respondents) are other important considerations in inventory policy changes.

Accounts Payable Management. For the majority of the Sri Lankan companies in the survey, accounts payable is controlled and managed by the finance manager or controller. Three-fourths of the respondents (27 out. of 36) maintain less accounts payable than accounts receivable. Six firms, however, maintain a high percentage of accounts payable and the remaining three have accounts payable approximately equal to their accounts receivable. Thus, the Sri Lankan manufacturing companies generally operate

Journal of Euro-Aslan Management


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on a deficit-credit basis, and as a consequence, depend on nonspontaneous sources for financing their trade deficits. The overall working capital policy and approach have significant effects on the credit position of many Sri Lankan firms. Most firms with accounts payable less than accounts receivable are medium-sized, high- profit-earning firms, and they follow informal and moderate or conservative working capital approaches . This is indicative of the conservative and risk-averse attitude of Sri Lankan managers in managing working capital finances. Companies with flexible working capital approach (changing over time) generally maintain accounts payable less than receivables . Overall, company size and profitability have no significant relationship with the credit position of the responding firms .

Cost of Accounts Payable. Do accounts payable involve a cost? For most of the Sri Lankan firms in the survey, accounts payable is a low or free of cost source of finance . About half of the responding companies ( 16 out of 33) report that they do not incur any cost; seven companies incur annual cost between 1.0% to 5.9%, and two greater than 15%. There is no relationship between the annual cost of trade and company size, profitability and working capital policy .

Cash Discount. The question of practice or policy on availing cash discount affects annual costs of trade supplies. Half of the responding companies (17 out of 33) always take the discount from their suppliers. Nine firms sometimes avail cash discounts and five never make use of this facility. There seems to be no relationship between cash discounts and size, profitability and working capital policies of the companies in Sri Lanka .

WORKING CAPITAL FUNDS Responsibility . In a large number of companies (26 out of 34 respondents), the finance manager is responsible for working capital funds management . The managing director is responsible in

Journal of Euro-AIIan Manago111ont

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about one-fourth (8 firms). In one company, the board of directors is involved in controlling short-term funds.

Purpose. Companies need working capital to meet their regular, seasonal and cyclical needs. More than half of the responding Sri Lankan firms (21 out of 36) use working capital for meeting their regular and constant needs. Six companies use working capital funds for financing their cyclical, five for non-spontaneous, while the remaining four, use such funds for seasonal needs. There seems to be some relationship between profitability and primary use of working capital funds (Table 4). Most highprofit-earning firms use working capital funds for regular and constant part of working capital, and most moderate-profit-earning companies use it to meet non-spontaneous needs. Low-profitearning companies use short-term working capital funds to finance both regular and cyclical needs of their business. There seems to be no significant relationship between the primary use of working capital funds and company size or working capital policy. However, it is observed that a number of companies requiring working capital funds for regular and constant needs are medium-sized, highprofit-earning companies that also follow informal and moderate working capital policies.

Sources. Banks are the major source of

financing for working capital in Sri Lanka. Bank sources come in a variety of forms. About two-thirds of the Sri Lankan manufacturing companies in the survey (23 out of 36) finance their working capital needs by using bank overdraft. Six companies use letters of credit and four companies utilize other short-term financing methods such as trust receipt loans (TR loan), working capital loans, bill discounting, import loans or a combination of overdrafs and over-night loans. There does not appear to be a definite relationship between working capital financing methods and company size, profitability or working capital policies. However, a number of companies that use overdrafts are medium-sized, high-profit-earning compames with informal and moderate working capital policies.

CQ

! £

Purpose

II

Total

Company size

s

M

Regu j21ll ·constant

5

Profitabil ity H

lflllrl 4

ital Funds Overall policy

:I A> CQ

Specific

3

approach

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90

Working Capital Management : Policies and Practices In Sri Lanka

Collateral. About two-fifths ( 15) of the responding manufacturing companies in Sri Lanka occasionally require collateral while 13 companies never need collateral for bank borrowing . This implies that in Sri Lanka, banks finance working capital loans depending upon the strength of the balance sheet figures. About 25% of the respondents (8 out of 36) always require collateral for bank loans . The requirement of collateral does not have any particular relationship with size, profitability or the working capital policy of companies . However, the results indicate that a number of high- profitearning, medium-sized firms that also follow informal and moderate working capital policy occasionally require collateral. Cost. What is the cost of working capital funds to Sri Lankan manufacturing companies? Working capital funds in Sri Lanka are expensive . Most companies (24 out of 36) in the survey have annual costs ranging from 15% to 19.9%. Less than 10% interestloans and greater than 20% interest-loans are availed by five companies . For two companies in the survey, the cost is between 10% to 14.9% and for five companies, it is less than 10%. Although the relationship between size, profitability or working capital policy with annual cost of working capital funds is not significant, it may be observed from the results that the companies that incur costs between 15% to 19.9% are high-profit-earning, medium-sized companies with informal and moderate working capital policies .

PLANNING AND CONTROLLING OF WORKING CAPITAL This section analyzes the Sri Lankan companies' working capital controlling techniques, cash budgeting methods, working capital management with ROI and implication of working capital policies for capital budgeting in practice .

Cash Budgeting. The main objective of most

Sri Lankan manufacturing companies in preparing cash budget is to plan for shortage and surplus of cash; - thirty out of 36 (83.3%) companies prepare cash budgets to forecast final cash surplus or shortage. The remaining six companies have different purposes like alternative sales forecasts, alternative credit terms, or alternative inventory policy .

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Seventeen out of 36 (47.42%) companies prepare monthly cash budgets while 10 companies prepare daily cash budgets. Most of the companies preparing daily cash budget are large-sized, high-profit-earning companies that also follow formal and aggressive working capital policies (Table 5). The situation is quite different in the case of companies preparing monthly b_udgets. Most of them are small-sized, medium-profit-earning, without a working capital policy and having a moderate approach. 25% of the respondents prepare cash budgets on a weekly basis. Quarterly cash budgeting is not very popular in Sri Lanka.

Monitoring. Current ratio is the most practiced technique for monitoring working capital in Sri Lanka. Twenty-one companies accord first priority to this technique. Working capital turnover is the next most important technique; twelve companies rate it as the number one technique. Working capital as a percentage of assets is used as the primary monitoring technique by only three companies. Other techniques used are: rollover budgets (cement company), limitation of bank facility (a textile company), seasonality (food product company), or sales (food product company). Evaluation of Working Capital Changes. How is the effect of changes in working capital components evaluated? The evaluation of working capital changes in terms of ROI is undertaken by Sri Lankan companies with different degrees of emphasis. Twenty-four out of 35 (68.57%) responding firms sometimes utilize return on investment criterion for evaluating changes in the management of working capital components. Six firms always use ROI, while the rest of the companies never consider ROI for evaluating changes in working capital components.

What hurdle rate is used to compare ROI resulting from the working capital changes? Twenty - seven out of thirty-five (75%) companies always use interest rate as a discount, or hwdle rate. The average cost of capital is used by seven out of 36 (19.4%) firms to evaluate changes in working capital. The cost of equity capital is used by one firm while one firm does not at all use discount or hurdle rate for evaluating working capital changes.


co

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Working

Capital

Management:

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and

Practices

in

Sri

Lanka

93

Working Capital and Capital Budgeting. Initial working capital is not always included in the evaluation of capital budgeting decisions by companies in Sri Lanka . Fifteen out of 35 responding firms infrequently consider initial working capital for the evaluation of capital budgeting decisions. Those companies that always consider initial working capital investment are medium-sized, high- profit earning companies with aggress ive working capital approaches . Seventeen out of 36 (4 7 .22%) firms always include and 14 out of 36 (38.89%) sometimes include changes in working capital components in capital budgeting projects. There seems to be a direct relationship between profitability and the tendency of including changes in working capital components as part of the capital budgeting projects . High- and medium- profit- earning firms are more inclined in conside ring the working capital changes in capital budgeting than the lowprofit- earning firms .

CONCLUSIONS Overall WC Policy . The managing director plays a major role in formulating working capital policies in majority of Sri Lankan companies. Large-sized companies generally implement formal policies while medium- and small-sized companies either have informal or no policy for working capital. Generally, companies follow an informal policy . Company size is an important factor vis- avis the working capital attitude, which is aggressive or moderate or conservative. Large-sized firms are more aggressive, medium- sized firms moderate and small-sized firms are generally conservative in managing their. working capital. The review of working capital varies according with company size . Large- and medium-sized companies review their policies on a monthly basis, while small- sized companies do not have any fixed · policy of review; it is most often situational.

Management of WC Components . Cur [ent -assets-holding - period is the primary method for estimating working capital needs. Moreover, estimation methods do not depend on company size, profitability or overall working capital policy .

Journal of Euro-Aalan Man•••••nt


The finance manager is most often responsible for cash management. Most companies follow verbal or written requests as a technique of reducing deposit floats. Stretching of credit is an important technique for increasing disbursement floats. Half of the survey companies have geographical bases in different provinces. They use depository transfer cheques for moving funds from one location to another . The finance managers of most companies consider character, capacity, capital, and business conditions when they grant credit to customers . Ageing schedule is the most important measure to monitor customer payment behavior. More than 90% of the respondents consider marketing and competitive considerations as the evaluating parameters for credit terms and policies . Effect on company sales is another important criterion in this regard. Most of the Sri Lankan manufacturing companies use the Material Requirement Plan (MRP) in deciding the appropriate amount of inventory to replenish . A majority of companies consider availability of parts and materials in deciding the replenishment quantities of inventory. For inventory control, most of the companies use Perpetual Inventory Control (PIC) system. The effect on the firm's profit is analyzed in evaluating proposed changes in the inventory policy. Companies that follow informal working capital policies maintain accounts payable less than accounts receivable, while companies without a policy for working capital have accounts payable greater than accounts receivable. Companies with formal policies maintain a balance between accounts receivable and accounts receivable . In general, aggressive firms have accounts payable greater than the accounts receivable; conservative and moderate firms keep their accounts payable less than the accounts receivable. However, a number of finance managers manage to obtain cash discounts from suppliers on time to minimize annual cost of trade credits .

Bank Finance for WC. High- profit- earning

firms always use commercial bank loans to finance the regular and constant part of

Journal of Euro·Aslan Managomont

Working

Capital

Management:

Policies

and

Practices

in

Sri

Lanka 95

the business cycle. Low- profit- earning and medium-sized firms use bank funds to finance cyclical and non-spontaneous needs, respectively. Most of the working capital funds are obtained from commercial banks as bank overdrafts. Annual cost of bank loans is generally between 15% to 20%.

Monitoring and Control. Most companies use current ratio for monitoring working capital over time. Cash budgets are prepared on a monthly basis for planning shortages and surpluses of cash. Return on investment is sometimes utilized for evaluating changes in the management of working capital components . A few companies consider the initial working capital in the capital budgeting projects. However, most companies except lowprofit-earning firms consider changes in working capital in capital budgeting decisions. 75% of the respondents use interest rate as a hurdle rate for evaluating changes in the management of working capital components.

Comparison of WCM Practices in Sri Lanka and the USA. Working capital practices in Sri Lanka are quite similar with the practices in the USA - a developed country (Exhibit 1) . However, the use of information technology differentiates the practices in the two countries. In the USA, companies use highly sophisticated information technology to manage working capital components. For example, American companies have computerized systems for inventory control. They also use faster methods of transferring funds. Furthermore, American companies invest their surplus cash in money market instruments. But because Sri Lanka is still in the developing stage, manufacturing companies in the country are not in a position of using advance information technology in managing their working capital. Also, the money market system in the country is not sufficiently developed to provide opportunity to companies to deploy their surplus cash profitably.

Journal of Euro-Aalan Manasomont

Working Capital Management: Policies and Practices

96

in Sri Lanka

Exhibit 1. Comparison of the WCM pradlces In Sri Lanka and the USA

USA

SRI LANKA

WCM POLICY Overall policy Formulation responsibility Review periodicity Estimation of we needs

Informal VP (fin .) Whenever necessary Percentage of sales

Approach

Situational

Informal Managing director Monthly Current-assets holding Moderate

MANAGEMENT OF WC COMPONENTS:

Cash Treasurer Lock boxes Centralised disbursing Wire transfer

Finance manager Verbal/written requests Stretching payable Depository transfer/ cheques

T reasurer Four C's of credit Ageing schedule Marketing and competition Effect on firm profit

Finance manager Four C's of credit Ageing schedule Marketing and competition Effect on firm profit

Primary responsibility Inventory replenishment Material purchase Production Control

Controller Computerized control Availability Production schedules

Policy changes

Effect on firm profit

Finance manger MRP Availability Production schedule Perpetual inventory Effect on firm profit

Controller AP less than AR Negligible Always take

Finance manager AP less than AR Negligible Always lake

Treasurer Non-spontaneous Line of credit Never require

Finance manager Regular & constant part Overdraft Occasionally require

Primary responsibility Deposit float reduction Disbursement float enhancement Internal fund movement

Receivable Primary responsibility Granting credit Monitoring Rationale for credit policy Policy evaluation focus

Inventory

Payable Primary responsibility Credit position Annual cost Cash discounts

we funds Primary responsibility Primary use Types of funds Collateral Annual cost

8 .0- 10.9%

15.0- 16.6%

leurnal ef lure-Asian Management


97

Exhibit 1. Comparison of the WCM practices in Sri Lanka and the USA (continued) USA SRI LANKA WC PLANNING & CONTROL: Controlling technique Interval of cash budget Purpose of cash budget ROI & W/C changes Discount rate Initial W/C in capital budgeting W/C changes in ca pital budgeting

Current ratio Daily Plan shortage & surplus Sometimes Average cost of capital

Current ratio Monthly Plan shortage & surplus Sometimes Interest role

Always

Sometimes

Sometimes

Always

REFERENCES [1)

Smith, K.V., Reading on the Management of Working Capital, second edition, West Publishing Company , San Francisco, 1978, pp 3-21.

[2) Cohan, R.A. and Pringle, J.J., "Steps Toward an Integration of Corporate Finance Theory", Reading on the Management of Working Capital, second edition, West Publishing Company , San Francisco, 1978, pp. 35-41. (3) Earnest, WW, "Toward Theory of Working Economist , Winter, 1964, PP. 21-35.

Capital",

Journal

of

Engineering

[4]

James, A.J.,"State of the Art of Short-run Financial Management", Financial Management, summer 1988, pp. 41-57.

[5]

Ned, C.H. and William, L.S. Short-term Financial Management , fourth Prentice Hall, Englewood Cliffs : New Jersy, 1995.

edition,

(6]

Smith, K.V. and Shirley, S.B., "Working Capital Management in Practicew, in Smith (ed.), op. cit, 1978, pp. 51-79.

[7]

Pradhan, R.S., Working Capital Management, first edition , National Book Organization, New Delhi, 1986; and Sishtla, V .SP., Working Capital Management in Public Enterprises, International Centre Publishing, Yugoslavia, 1992.

[8)

Smith and Shirley , 1978, op.cit.

[9)

Lewellen, W. G. and Johnson, R. W. "Better Ways to Monitor Receivable", Harvard Business Review , May-June, 1972, pp.101-119.

Accounts

Journal of Euro-Aalan Manago•ont