Working capital management
The Project Report is a summary of Study of some of the elements of Working Capital Management at the Heavy Engineering Division of Larsen & Toubro Limited (L&T, HED). The various aspects of these working capital elements have been studied. The Study of working capital management involved understanding of receivables, payables and to an extent inventory management. After a brief introduction to the nature of Business activity of Larsen & Toubro and its Business Division - Heavy Engineering Division, the report comprises a detailed comparison of Heavy Engineering Division's performance with its Indian and Foreign Competitors. The comparison is based on profitability, productivity and working capital management aspects. The basis for conducting this study has been ratio analysis. The second phase of the Project report deals with the various aspects of Working capital Management. An effort has been made further to suggest alternatives / recommendations in order to improve the performance of Payables management at HED. Some of these alternatives include viability study of Futures contracting for high value items procured, rationalization of the supplier base by means of consolidation etc. The report also includes a brief study about Receivables Management at Larsen & Toubro, Heavy Engineering Division.
The basic aim of the project is to study the Management of Working Capital at Heavy Engineering Division of Larsen & Toubro Limited. The project is divided into the following
1. Study of current performance of working capital Management (Receivables, Payables and Inventory Management) at L&T, HED based on Ratio Analysis.
2. Study of Receivables Management and observations.
3. Study of Payables Management Process in detail and observations.
Methodology And Data Collection Methods
The basic type of research used to prepare this report is Descriptive. The major purpose of descriptive research is to give a description of the state of affairs, as it exists during the time of study. The main characteristic of this method is that researcher has limited control over the variables affecting the study. The researcher can only report what has happened or what is happening. What, Where, When, How are the questions that can be answered by the researcher and not “Why”. Descriptive Report is that subscription which answers or addresses all these questions.
The study is mainly based on the secondary data which refers to that form of information that has already been collected and is available. These include some internal sources such as annual reports and some amount of first hand information which could be gathered through one of the team members, engaged as a supplier to the company. Some of the external sources of data collection include competitor websites for annual report, research papers etc. Other sources include books and periodicals, published reports. For the measurement of performance of the Heavy Engineering Division and comparison with its competitors, the data has been sourced from the annual reports available for L&T.
The period of study is Five Years i.e. the data and the financial results for the period 2003-2007 has been taken into consideration for analysis and calculations. In the case of data for Indian competitors, financial results have been accessed using Prowess and other internet resources. For financial results of foreign competitors, company websites have served as the main data source. Other sources have been SEC (EDGAR) from the United States of America where all the mandatory filings for companies are available. Various other stock exchange websites for different countries have been listed in detail in the reference section.
For the Payables management and Receivables management study, information has been collected as much as possible from the net. In order to study the viability of alternatives such as futures trading for high value materials, a detailed study was possible through website resources such as NCDEX and London Metal exchange.
Limitations Of The Study
The annual reports available from the company websites and other databases for conglomerates are for the entire organization. It is not possible to get divisional reports of organizations such as BHEL, Godrej & Boyce etc. This makes the ratio analysis somewhat inaccurate. However, it is a good indication of the performance of the company.
About Larsen & Toubro Limited
Larsen & Toubro Limited (L&T) is a technology-driven Engineering and Construction organization and one of the largest companies in India's private sector. It has additional interests in Information Technology and Services. L&T was founded by two Danish engineers, Henning Holck-Larsen and Soren Kristian Toubro, in 1938. Beginning with the import of machinery from Europe, L&T rapidly took on engineering and construction assignments of increasing sophistication. It now has a major presence in key sectors of the economy. A strong, customer-focused approach and the constant quest for top-class quality has enabled the Company to attain and sustain leadership in its major lines of business across seven decades. With factories and offices located around the country, further supplemented by a comprehensive marketing and distribution network, L&T enjoys an image and equity in virtually every district of India.
With revenues to the tune of more than Rs. 18,000 crores reported for the financial year ending March 2007 and employee strength of over 20,000, Larsen & Toubro Limited is one of the stalwarts in the Indian Economy. The Company has an international presence, with a global spread of offices and joint ventures all round the globe. L&T's large technology base and pool of experienced personnel enable it to offer integrated services in world markets. Larsen & Toubro Limited has divided its Business Activities into primarily the following Divisions:
Larsen & Toubro Limited - Heavy Engineering Division
L&T's Heavy Engineering business activities are organized under self-reliant Strategic Business Units (SBU's), each specializing in specific industry sectors. Together, they cater to the needs of core-sector industries and the defense sector. Good business prospects and major capacity additions geared up the Heavy Engineering Division to mop up revenues to the tune of Rs. 1440 crores for the Financial Year ending March 2007. The Division operates at the upper end of the technology spectrum and has, for over six decades, been at the forefront of introducing new processes, products and materials into Indian manufacturing. L&T has state-of-the art manufacturing facilities which are capable of meeting the challenges of technology, quality conformance and delivery, while ensuring cost competitiveness. Heavy Engineering Division has been further divided on the basis of the business activity into number of strategic business units (SBU's).
Break up Of L&T Heavy Engineering Division activities
A. Process Plant Equipment
L&T's Heavy Engineering Division caters to equipment for process industries worldwide, including fertilizer, petro-chemical, refinery, cracker, oil & gas, chemical, cement and power sectors. L&T is now at the threshold of a major growth phase in the world market with a successful entry into the new business of key equipment for coal gasification, viz. Coal Gasifiers and syngas coolers. The Division is geared and qualified for manufacture and supply of heavy and large sized Gas-to-Liquid (GTL) reactors. L&T works with an exhaustive array of materials including low and high alloy steels, stainless and duplex stainless steels, clad and overlaid steels, exotic materials such as nickel, Monel, Inconel, Cupro-Nickel, Copper, Hastelloy, Aluminum, Titanium, Zirconium, Tantalum and new-age composites. Manufacturing activities are supported by capabilities in thermal and mechanical design, special analysis - including stress and vibration analysis, engineering, purchase logistics and specialized services for site-work, erection & commissioning. L&T has been associated with leading EPC contractors and engineering consultants. Large numbers of critical equipment have been exported to every continent including North America, South America, Europe, the Middle East, South Africa, the former Soviet Union, Australia and the Asia-Pacific region.
The strategic business units for Process Plant Equipment are as below:
- Fertilizer, Petrochemical & Heat Transfer Equipment (FPEX)
- Coal Gasifiers & Thermal Power Plant Equipment (CGPP)
- Refinery, Cracker Plant and Oil & Gas Equipment (RCOG)
B. Defense, Nuclear Power & Aerospace
Defense Business Unit (ARMY, WSAS & MARI) - L&T has been issued letters of intent (LOI's) for industrial license for a wide range of products, after the Govt. of India's decision to open up Defense production to the private sector. The LOI's issued to L&T cover design, development and construction / manufacture of warships, submarines, weapon platforms & launchers, field & air defense guns, anti-tank weapon systems, missiles, rockets, torpedoes, land / naval mines including associated systems and subsystems, RADAR, SONAR, sensors, armored & combat vehicles, airborne assemblies, systems and equipment for aircraft, helicopters and UAV, etc
L&T's current product range, built largely through in-house R&D, includes:
- Land-based weapon launch systems
- Multi-mode Universal Missile Launcher
- Multi Barrel Rocket Launcher
- Anti Tank Guided Missile Carrier
- Quick Reaction Surface-to-Air Missile Launcher
Nuclear Power Plant Equipment Business Unit (NUCL) - A pioneer in the field of manufacturing technology development, equipment manufacture and site / plant services for nuclear power plants, L&T is a recipient of the prestigious ”INS Industrial Excellence Award” - for outstanding contribution in the nuclear power sector. L&T's current product range for this sector includes equipment for pressurized heavy water reactors, fast breeder reactors, heavy water plants and fuel reprocessing plants. The range includes equipment such as end shields, calandria, steam generators, primary heat transport systems, heavy water upgrading columns, reactivity control rods & drive mechanisms, roof slab, fuel transfer arm, exchange unit towers and internals, high pressure heat exchangers, high and low level waste storage tanks, fuelling machine carriage and trolley. L&T also offers site services in new and operating plants such as enmass coolant channel replacement, installation of end shield and calandria, coolant channel assembly and reactivity devices.
Aerospace Equipment Business Unit (AERO) - L&T offers design, manufacture and supply of components, subsystems and systems for aerospace applications. L&T's precision manufacturing facilities are geared to meet the exacting demands of aerospace manufacture. A range of state-of-the art facilities gives L&T, the capability to achieve high accuracy levels in the manufacture of systems & sub-systems of satellites & launch vehicles in metals and in advanced composites. L&T has also carried out in-house development of welding procedures for exotic materials and special machining processes for space application such as mar aging steel, 15CdV6, titanium alloys, silicon steel and special alloy steel. L&T's current range of products includes rocket motor casings, convergent and divergent nozzles, titanium gas bottles for liquid stages, titanium tanks for liquid upper stages for launch vehicles; C-band & S-band tracking radars; solar array deployment mechanisms for satellites; special purpose machines; jigs and fixtures for critical applications. L&T is gearing up for larger participation in space programs and for manufacture of subassemblies, systems and sub-systems
Powai - Fabrication shops have a built-up area of 46,000 sq.m. They are equipped with sophisticated facilities for fabrication, machining, handling and quality control. Over 1,000 highly trained and multi-skilled craftsmen form the core strength of the shops. L&T's advanced technology and high standard of specialization facilitate the manufacture of high quality heavy equipment of thicknesses up to 250mm in mono-block construction with individual sections weighing over 300T. Specialized fabrication facilities include a CNC-controlled gas/plasma profile cutting machine,
edge planning / milling machine, a 100,000 class dust-free enclosure with an area of 400 sq.m., a 1000T hydraulic press, heavy duty plate bending rolls of capacity 90mm thickness in cold and 180mm thickness in hot condition, deep hole drilling capabilities of up to 900mm thickness, CNC horizontal boring machines with 200mm spindle dia., CNC vertical boring machines of up to 8500mm dia. And 60T load, facing and turning lathe of 6000mm dia. And 100T weight between centers and welding machines for a variety of processes such as submerged arc, TIG, MIG, automatic pulse TIG tube-to-tube sheet welding, strip cladding, FCAW over-lay, internal bore welding, etc. The shops are also provided with EOT cranes of 80T capacity, heavy duty welding manipulators, and large furnaces for plate heating and heat treatment of equipment as well as X-ray enclosures of size up to 25m x 10m x 10m. The shops are also equipped with facilities for raw material processing, manufacture and specialized testing of composite multilayered structures.
Hazira - This modern, coastal heavy engineering complex, situated on a 200-acre plot, is located near Surat in Gujarat. The factory buildings cover an area of over 34,500 sq.m. This is a coastal facility, with a load out quay on the banks of the river Tapi close to the Arabian Sea. The complex has an open fabrication yard of around 200,000 sq.m, which is being further expanded. Material-handling equipment in this yard includes a 400T capacity gantry crane, reinforced hydro test bed, etc. Load out wharf length: 250m. Roll-on roll-off slipway: 40m wide, a 1000 sq.m. dust-free enclosure, 350T capacity heat treatment and 125T capacity plate heating furnaces, plate rolling capacity up to 250mm thickness, radiography up to 500mm thickness, 1200T capacity alignment and welding system, laser weld tracking systems, closed loop flux recycling systems, etc. The fabrication activities are complemented by well-equipped machine shops with sophisticated CNC vertical and horizontal boring machines which are capable of handling jobs as large as 12,000mm diameter and 130T weight. L&T's Hazira Works is equipped to manufacture extra-large and very heavy equipment for power projects, chemical, refinery, petrochemical and fertilizer industries, oil exploration, and marine-related sectors. This equipment can be shipped out via waterways.
Vadodara (Ranoli Works) - L&T's Ranoli Workshop (RNW) is in Vadodara, Gujarat and is located around 10 km from the airport. This world-class workshop is a dedicated facility for fabrication of stainless steel, aluminium, inconel and other exotic materials. It is ISO 9001 accredited and authorized to use ASME ‘U' stamp. It enjoys a very favorable reputation and evaluation from a wide spectrum of clients from process industry including refinery, petrochemicals, fertilizers, aerospace, power and food industry. Sophisticated equipment manufactured for the domestic and export markets include reactor internals; specialty internals such as cyclones (with refractory anchors and refractory application) and separators; pressure vessels, towers and heat exchangers; cold box for air separation plant; fuel tanks for helicopters; spray dryers; fluid bed, vibro - fluid bed and flash dryers; vacuum systems and many more.
Finance Department at Heavy Engineering Division of Larsen & Toubro
Larsen and Toubro Limited is a conglomerate comprising of a number of Business divisions. There is a centralized L&T Corporate Finance department which further branches out into individual Finance & Accounts departments for its various Business Divisions. The overall Financing, Sourcing and Investment decisions for all the business divisions of L&T is handled by the Corporate Finance Department at the headquarters. The role of the individual finance departments of various divisions is to manage the operational aspects of financial management. The finance department of HED Powai comprises of 32 personnel handling different areas of Finance & Accounts such as payables, receivables, cash management, treasury, taxation, payroll and budget.
Introduction To Working Capital Management
The term working capital refers to the amount of capital which is readily available to an organization. The difference between current assets and current liabilities is known as net working capital, but financial managers often refer to the difference simply (but imprecisely) as working capital. That is, working capital is the difference between resources in cash or readily convertible into cash (Current Assets) and organizational commitments for which cash will soon be required (Current Liabilities). In a firm's Statement of Financial Position, these components of working capital are reported under the following headings:
- Liquid Assets (cash and bank deposits)
- Bank Overdraft
- Creditors and Payables
- Other Short Term Liabilities
Determinants Of Working Capital:
The working capital requirements of a concern depend upon a large number of factors. It is not possible to rank them because all such factors are of different importance and the influence of individual factors changes for a firm over time. However the following are the factors generally influencing the working capital requirements.
Nature Or Character Or Business
The working capital requirements of a firm basically depend upon the Nature of the business. Public undertakings like electricity, water supply, and railways need very limited working capital because they offer cash sales only and supply services. Trading and financial firms require less investment in fixed assets but have to invest large amounts in current assets, as they need large amount of working capital. The manufacturing companies like L&T HED require sizable working capital along with fixed investments.
Size Of Business
The working capital requirements of a concern are directly influenced by the size of the business. Greater the size of a business unit, generally larger will be the requirements of working capital.
The requirements of a working capital depend upon the production policy. The production could be kept either steady by accumulating inventories during slack periods with a view to meet high demand during the peak season or the production could be curtailed during the slack season and increased during the peak season. If the policy is to keep production steady by accumulating inventories it will require higher working capital.
In manufacturing business, the requirements of working capital increase in direct proportion to length of manufacturing process. Longer the process period of manufacture, larger is the amount of working capital required. The longer the manufacturing time, the raw material and other supplies have to be carried for a longer period in the process with progressive increment of labor and service costs the finished product is finally obtained.
In certain industries raw material is not available throughout the year. They have to buy raw materials in bulk during the season to ensure the uninterrupted flow and process them during the entire year. A huge amount is thus blocked in the form of material inventories during such seasons, which gives rise to more working capital requirements.
Working Capital Cycle
In a manufacturing concern, the working capital cycle starts with the purchase of raw material and ends with realization of cash from the sale of finished goods and this cycle continues again from cash to purchase of raw material and so on.
Rate Of Stock Turnover
There is a high degree of inverse co-relationship between the quantum of working capital and the velocity or speed with which the sales are affected. A firm having a high rate of stock turnover will need lower amount of working capital as compared to a firm having low rate of turnover.
Firm's Credit Policy
A concern that purchases its requirements on credit and sells its products/ services on cash requires lesser amount of working capital. On the other hand the concern buying its requirements for cash and allowing credit to its customers shall need larger amount of working capital.
Advantages Of Adequate Working Capital
Solvency Of Business
Adequate working capital helps in maintaining Solvency of the business by providing uninterrupted flow of production.
Sufficient working capital enables a business concern to make prompt payments and hence helps in creating and maintaining goodwill.
A concern having adequate working capital, high solvency and good credit standing can arrange loans form the banks and others on easy and favorable terms.
Adequate working capital also enables a concern to avail Cash discounts on the purchases and hence reduces costs.
Regular Supply Of Raw Materials
Sufficient working capital ensures regular supply of raw materials and continuous production.
Regular Payments Of Salaries, Wages And Other Day-To-Day Commitments
A company which has ample working capital can make regular payments of salaries, wages and other day-to-day commitments which raise the morale of its employees, increases their efficiency,
reduces wastages and costs and enhances production and profits.
Exploitation Of Favorable Market Conditions
Only concerns with adequate capital can exploit favorable market conditions such as purchasing its requirements in bulk when the prices are lower and by holding inventories for higher prices.
Ability to face crises
Adequate working capital enables a concern to face business crises in emergencies such as depression because during such periods, generally, there is much pressure on working capital.
Quick And Regular Return On Investments
Every investor wants a quick and regular return on his investments. Sufficiency of working capital enables a concern to pay quick and regular dividends to its investors, as there may not be much pressure to plough back profits. This gains the confidence of its investors and creates a favorable market to raise additional funds in the future.
Adequacy of working capital creates an environment of Security, confidence, high morale and creates overall efficiency in a business.
Disadvantages Of Redundant Or Excessive Working Capital
- Excessive Working capital means idle funds, which earn no profit for the business, and hence the business cannot earn proper return of investments.
- When there is a redundant Working capital it may lead to unnecessary Purchasing and accumulation of inventories causing more challenges of theft, losses and waste.
- Excessive Working capital implies excessive debtors and defective Credit policy, which may cause higher incidents of bad debts.
- It may result into overall inefficiency in the organization.
- When there is Excessive Working capital, relations with the bank and other financial institutions may not be maintained.
- Due to low rate of return on investments, the value of shares may also fall.
Dangers Of Inadequate Working Capital
- A concern, which has Inadequate Working capital, cannot pay its short term liabilities in time. Thus, it will lose its reputation and shall not be able to get good credit facilities.
- It cannot buy its requirements in bulk and cannot avail of discounts.
- It becomes difficult for the firm to exploit favorable market conditions and undertake profitable projects due to lack of Working capital.
- The firm cannot pay day-to-day expenses of its operations and creates inefficiencies, increases costs and reduces the profits of the business.
- It becomes impossible to utilize the fixed assets efficiently due to non-availability of liquid funds.
- The rate of return on investments also falls with the shortage of working capital.
Functionality of Working Capital
A firm's balance sheet at the beginning of the process has cash (a current asset). After a lapse of certain period of time, the cash is replaced first by inventories of raw materials which is then converted into Work in progress inventory and further into inventories of finished goods (also current assets). When the goods are sold, the inventories give way to accounts receivable (another form of current asset) and finally, when the customers pay their bills, the firm takes out its profit and replenishes the cash balance. The components of working capital constantly change with the cycle of operations, but the amount of working capital is more or less fixed for a cycle of operations. Hence net working capital can be used as a summary measure of current assets and liabilities for a firm. The whole process for working capital cycle is shown below in figure 1
Figure 2 depicts four key dates in the production cycle that influence the firm's investment in working capital. The firm starts the cycle by purchasing raw materials, but it does not pay for them immediately. This delay is the Accounts Payable Period or Creditors Deferral Period. The firm processes the raw material and then sells the finished goods. The delay between the initial investment in inventories and the sale date is the Inventory Conversion Period The inventory Period comprises of Raw Material Conversion Period, Work In Progress Conversion Period and Finished Goods Conversion Period. Sometime after the firm has sold the goods, its customers pay their bills. The delay between the date of sale and the date at which the firm is paid is the Accounts Receivable Period or Debtors Collection Period. It is evident that the total delay between initial purchase of raw materials and ultimate payments from customers is the sum of the inventory and accounts receivable periods, also known as Gross Operating Cycle. The net time that the company is out of cash is reduced by the time it takes to pay its own bills. The length of time between the firm's payment for its raw materials and the collection of payment from the customer is known as the firm's Cash Conversion Cycle or Net Operating Cycle.
Cash conversion cycle = (inventory period + receivables period)
1. Accounts payable period
The Working Capital Trade - off
The cash conversion cycle or the net operating cycle is not cast in stone but depends on a large extent on the management of the company. For example, accounts receivable are affected by the terms of credit, the firm offers to its customers. A firm can cut the amount of money tied up in receivables by getting tough with customers who are slow in paying their bills. However, in the future the firm may loose its customers. Similarly, the firm can reduce its investment in inventories of raw materials. Here, the risk is that it may run out of inventories and production will grind to a halt. A firm can also decide upon extending its credit terms with its suppliers so that it has more cash to play with. However, suppliers may be indifferent with this step and this may hamper delivery of supplies. These considerations show that investment in working capital has both costs and benefits. Working capital constitutes part of the Crown's investment in a company. Associated with this is an opportunity cost to the Crown. (Money invested in one area may “cost” opportunities for investment in other areas.) If a company is operating with more working capital than is necessary, this over-investment represents an unnecessary cost to the Crown. From a Company's point of view, excess working capital means operating inefficiencies.
Approaches To Working Capital Management
The objective of a firm should be to maintain the optimum balance of each of the working capital components. This includes making sure that funds are held as cash in bank deposits for as long as and in the largest amounts possible, thereby maximizing the interest earned. However, such cash may more appropriately be invested in other assets or in reducing other liabilities. There are different ways to study the Working Capital Management of a firm. When considering these techniques and strategies, one needs to recognize that each firm has a unique mix of working capital components. The emphasis that needs to be placed on each component varies depending upon the business activity of the firm. For example, some companies have significant inventory levels whereas others have negligible. Furthermore, working capital management is not an end in itself but an integral part of the firm's overall management. The needs of efficient working capital management must be considered in relation to other aspects of the department's financial and non-financial performance.
Financial Ratio Analysis
One of the most commonly used methods in measuring the performance of the firm is the ratio analysis. Ratio analysis is used to analyze the overall trends in working capital and to identify areas requiring closer management. A comparative analysis amongst competitors can be used as one of the benchmarking strategies. Financial ratio analysis calculates and compares various ratios of amounts and balances taken from the financial statements. The main purposes of working capital ratio analysis are:
1. To indicate working capital management performance
2. To assist in identifying areas requiring closer management.
Three Key Points Need To Be Taken Into Account When Analyzing Financial Ratios:
1. The results are based on highly summarized information. Consequently, situations which require control might not be apparent, or situations which do not warrant significant effort might be unnecessarily highlighted.
2. Different departments face very different situations. Comparisons between them, or with global ideal ratio values, can be misleading.
3. Ratio analysis is somewhat one-sided; favorable results mean little, whereas unfavorable results are usually significant.
However, financial ratio analysis is valuable because it raises questions and indicates direction for more detailed investigation.
Comparitive Analysis With Indian & Foreign Competitors
A detailed analysis of performance of L&T HED with its competitors was conducted on the Profitability, productivity and working capital management front. However, the working capital ratios and the turnover ratios will be concentrated upon in the project report. The competitor list is based on the information provided by the company's internal sources. The list has been classified into 2 categories - Indian Competitors and Foreign Competitors
1. Bharat Heavy Electricals LimitedSales - 15000 crores as on year end 2007
2. Andhra Pradesh Heavy Engineering & Machinery Limited. Sales - 75 crores as on year end 2007
3. Walchandnagar Industries Limited.Sales - 400 crores as on year end 2007
4. Godrej & Boyce Mfg Co.Sales - 2000 crores as on year end 2007.
For comparison with Indian Companies, the period 2001 - 2007 has been considered. The data for Andhra Pradesh
Heavy Engineering & Machinery Limited was also unavailable for the year 2002.
1. Daekyung Machinery & EngineeringSales - 155,700 Mn Won
2. Doosan Heavy Ind. & Const Sales - 2455,500 Mn Won
1. Hitachi ZonsenSales - 333881 Million Yen
Note - The Data for foreign competitors was available for the years 2005 - 2007.
Inventory Conversion Period (INVCP) - It is the total time needed for producing and selling the product. Inventory conversion period explains how efficiently the company converts inventory into sale. If a company can quickly sell its inventory, then the Inventory Turnover will be higher thus resulting in a lower INVCP.
INVCP comprises of Raw Material Conversion Period (PMCP), work in progress conversion period (WIPCP) and finished goods conversion period (FGCP).
Invcp = 360 / Inventory Turnover
Inventory Turnover = Sales / Average Inventory
The INVCP for L&T, HED is lower than its Indian competitors in the Industry. As L&T, HED has managed to bring it down drastically to around 150 days from 1990's to 58 on year ending 2007, the performance can still be bettered. When compared with the Foreign Competitors, it can be seen that the performance of Japanese and Korean companies is superior to that of Indian Companies. The one important factor for a high INVCP is the presence of very high work in progress inventory which accounts to more than 80% of the inventory. The presence of high WIP inventory can be attributed to the nature of Business activity which L&T HED deals in.
Debtors Collection period (DCP) - It is the time required to collect the outstanding amount from the customers. It explains how quickly a company converts its credit sales into cash for running the business. If the collections are quick, the debtor's turnover will be high which means a lowed DCP.
DCP = 360 / DEBTOR'S TURNOVER
Debtors Turnover = Sales / Average Debtors
Debtor's collection period has been fairly constant over the past 5 years. It stood just above 100 days as on year end 2007 which is in between when compared with the Indian competitors of HED. Hence it can be stated that the performance of L&T HED in customer's payment collection is not that much superior with respect to Indian but it is second best for foreign competitors. The higher collection period for L&T may be due to a direct impact of country specific policies for payment practices.
Creditor's deferral period (CDP) - It is the length of time the firm is able to defer the payments on various resource purchases. It is also known as the average time taken by the firm in paying its suppliers. Higher the CDP, better the credit availed by the firm thus resulting in a lower working capital requirement.
CDP = 360 / CREDITORS TURNOVER
Creditors Turnover = Sales / Average Creditors
The CDP can be considered as a matter of concern for L&T, HED in terms of foreign competitors. But it is good when compared to its Indian competitors. Further alternatives can be explored in terms of credit policy and other operational aspects in order to extend the CDP. The performance of competitors such as Daekyung Industries Ltd is also better when it comes to deferral in creditor's payments.
Gross operating Cycle (GOC) - It is the sum total of the Inventory Conversion Period and the Debtor's Collection Period. Every firm's aim should be to have a very low value of GOC. Lower the GOC, lower will be the investment required in the working capital for the firm.
GOC = INVCP + DCP
It is evident from the above depicted graphs that L&T, HED has been successful in consistently bringing down the GOC which stood at 188 days in the year 2003 to below 165 days mark as of year ending 2007. The value for the year 2007 (163 days) is more comparable with its competitors in the Industry. The high value of GOC can be attributed mainly to the high INVCP which is a direct impact of work in progress inventory conversion period as explained earlier.
Net Operating Cycle (NOC) - The difference between Gross Operating Cycle and Creditor's deferral period is termed as Net Operating Cycle. It is also known as Cash Conversion Cycle. It is the net time interval between cash collections from sale of product and cash payments for resources.
NOC = GOC - CDP
NOC has come down drastically over the past few years and can be now compared with some of the small players in the market such as Walchandnagar. As the NOC is higher than most of its competitors there is scope for improvement by means of reducing work in progress conversion periods and increasing the creditor's deferral period. The NOC calculated above does not consider the advances received from customers.
Current Ratio - It is the measure of the firm's short term solvency. It indicates the availability of current assets for every one rupee of current liability. Although, a current ratio of 2:1 is considered as a standard benchmark in any industry, this ratio is only a measure of quantity and not quality. It differs from industry to industry based on its nature and Business domain.
CURRENT RATIO = CURRENT ASSETS / CURRENT LIABILITIES
We can see from the charts above that the liquidity position of HED has been fluctuating over the past few years. The current ratio has come down from 1.345 in the year 2005 to 1.1 as on year ending 2007. This suggests that Current liabilities are just equal to current assets for the year 2007. When compared with its competitors, it can be seen that the overall current ratio maintained by the companies in this particular industry is on the lower side as compared to the standard benchmark of nearly 2. In case of foreign competitors too, it can be seen that there are a significant number of companies maintaining a current ratio equitant to that of L&T HED. If we take a look at the graph which gives the status of structure of funding, we can see that current liabilities (short term funding) is being used as a source of funds not only for current assets but also for fixed assets in the year 2006. The ratio of CA / CL has always been on the lower side for HED which suggests a more aggressive stance of financing and liquidity management as far as working capital is concerned. This may be attributed to the fact that HED resorts to L&T Corporate for its funding requirement. The sourcing of funds from the market is a task wholly carried out by L&T Corporate and not HED. Hence HED finance can be reasonably confident of getting hold of the funds as per their projected cash flow predictions.
Quick Ratio - This ratio establishes relationship between liquid assets and current liabilities. Inventories are considered to be less liquid than other current assets. Hence quick ratio does not include inventories in its computation. It is given as
QUICK RATIO = (CURRENT ASSETS - INVENTORY) / CURRENT LIABILITIES
It can be implied from the low values of quick ratio that inventory forms a major chunk of the current assets and the proportion of inventory to other current assets is very high. The latest calculated current ratio for L&T, HED is the lowest amongst its competitors. L&T HED does not have to maintain a minimum cash balance to ensure liquidity for payments. It can resort to L&T Corporate for financing its immediate requirement. This is one of the reasons behind the low values of quick ratios.
Asset Turnover Ratios - These ratios are used to ascertain the efficiency with which a firm is utilizing its assets (Total and Current).
TOTAL ASSET TURNOVER = SALES / TOTAL ASSETS
CURRENT ASSET TURNOVER = SALES / CURRENT ASSETS
Although, the performance of L&T HED on the profitability front is very good and can be compared with the best in the industry, the asset turnover ratios (Total Asset and Current asset turnover) are on the lower side. This is a direct impact of slow moving work in progress inventory. The amount of working capital blocked in the work in progress inventory is also on the higher side. The reason behind high work in progress inventory can be attributed to the nature of business activity that HED is involved in.
Conclusions From Ratio Analysis
- From the balance sheets of all the firms under study, it was observed that the gross profit margin(GROSS PROFIT/SALES) and net profit margin(NET PROFIT/SALES) for L&T HED was the best in the industry as compared to Indian and Foreign competitors. The Operating profit margin and the Return on Investment is the best amongst the industry competitors. HED is one of the most profitable Business Divisions of Larsen & Toubro Limited.
- The inventory turnover is on the lower side for L&T, HED. This has reflected in a very high inventory conversion period. The main factor contributing to this is the presence of very high work in progress inventory. The work in progress inventory comprises of 80% of the total Inventory. This is the case in most of the industry competitors. The nature of business activity that HED deals in which comprises of manufacturing of long lead cycle equipments is the reason behind the high work in progress conversion period.
- Debtor's collection period has been constant over the past 5 years. It stands at below 60 days as on year end 2007 which is the lowest when compared with the Indian as well as foreign competitors of L&T, HED. Hence it can be stated that the performance of L&T HED in customer's payment collection is far superior not only with respect to Indian but also its foreign competitors. The higher collection period for foreign competitors may be a direct impact of country specific policies for payment practices. Another reason behind high collection periods in countries such as Japan and Korea may be due to the low interest rates as compared to the Prime lending rates in India.
- The performance of L&T, HED in terms of deferring creditor's payments can be improved. The Creditor's deferral period (CDP) is quite low compared to its Indian as well as foreign competitors. Extending the deferral period may be possible through better credit terms and operational aspects involved in managing payables. The performance of small competitors such as Walchandnagar Industries Ltd is also better when it comes to deferral in creditor's payments. Although the charts may suggest a better performance of Indian competitors, the market sentiment of L&T, HED amongst its creditors (suppliers) can be considered as one of the best in the Industry.
- The high values for gross operating cycle is a direct impact of high inventory conversion periods and the low creditors deferral period respectively. However, it can be seen from the net operating cycle of L&T HED that the advance payments from customers contribute significantly and suffice the working capital needs of L&T, HED.
- The stance taken for financing the current assets is more of an aggressive nature. The current ratio has gone just above 1 as on year ending 2007. This suggests that Current liabilities are equivalent to current assets for the year 2007. This can be attributed to the fact that Heavy Engineering Division can be reasonably sure of its liquidity position as it resorts to Larsen & Toubro Limited (Corporate Finance) for sourcing and financing of funds as and when required. The increase in volume of sales in the last couple of years has resulted in an increased inflow of cash in the form of advance payments. The advance payment rise has resulted in a jump in current liabilities. These advance payments from customers are significant and are sufficient to meet the working capital needs of L&T HED up to a large extent.
- Although the profitability and productivity ratios are on the higher side amongst its competitors for HED, the values for current and total asset turnover are lower. This is mainly due to the fact that more working capital in the form of inventory is required for the smooth functioning of the business.
Importance Of Receivables And Payables Management
After conducting a detailed ratio analysis for the various working capital ratios, it was found that an increase in CDP or a decrease in DCP has a significant impact on the working capital needs of the firm. The importance of stretching the CDP and decreasing the DCP has been further elaborated below:
Debtors Collection period
For the year 2007, figures from the annual report are as follows-
Debtors' collection period-101.11
It can be seen from the graph and from calculations that, if the Debtors collection period is reduced by 1 day, the average value of funds blocked in debtors works out to Rs. 143 crores. Thus there is a reduction of Rs. 3.2 crores in working capital requirement and a consequential interest saving of Rs. 38.4 Lacs (Considering Cost of funds @ 12%.
Creditors Deferral Period
For the year 2007, the figures for L&T HED (as per annual report) were :
Average value of credit availed from suppliers - Rs.129.4 crores.
Credit Purchases - Rs. 685.4 crores
Creditors Deferral period - 110 days
An increase in Creditors deferral period by 1 day results in an increase of credit availed from suppliers to Rs. 131.4 crores. Thus there is a reduction of Rs. 2 crores in the working capital requirement and a consequential interest saving of Rs. 24 Lacs (Considering Cost of funds @12%).
Thus a cumulative effect of an increase of 1 day in CDP and a decrease of 1 day in DCP results in a decrease in average funds blocked in working capital by 3.2+2 = 5.2 crores and an interest spend saving of Rs. 59 lacs. The significance of impact of change in collection and deferral periods on working capital needs of a firm cannot be undermined and is of vital importance for a Finance Manager.
Study Of Receivables Management At Heavy Engineering Division
The ratio analysis measured the performance of L&T, HED with respect to various working capital ratios. From the ratio analysis, it was observed that the performance of L&T, HED in terms of debtor's turnover and the collection period can be considered better than most of its competitors. In this section of the project report, a study of the various aspects of receivables management has been conducted in brief. An analysis has been conducted for outstanding receivables and the nature of clientele for L&T, HED.
Importance of Receivables Management
Trade credit arises when a firm sells its products or services on credit and does not receive cash immediately. It is an essential marketing tool, acting as a bridge for the movement of goods through production and distribution stages to customers. A firm grants trade credit to protect sales from the competitors and to attract the potential customers to buy its products at favorable terms. Trade credit creates Accounts receivable that the firm is expected to collect in the near future. A credit sale has 3 important characteristics:
1. It involves an element of risk as the cash payments are yet to be received. Thus they should be carefully analyzed.
2. It is based on the economic value. To the buyer, the economic value of goods passes immediately at the time of sale, while the seller expects an equivalent value to be received later on.
3. It implies futurity. The buyer will make the cash payment for goods received by him in a future period.
Creating value by optimizing cash flow and profitability is a fundamental challenge for all businesses. Responding to this challenge means focusing on the factors that you can directly influence rather than being diverted by external influences over which you have little control. One of the significant - but often overlooked - levers to increase Cash flow and profitability is the order to cash cycle. Getting this right will make a substantial contribution to the business, whilst inefficient working practices undermine both profitability and customer service.
- However, just as every business is different, so too are the challenges and opportunities each faces in making sure that they get their order to cash cycle operating at the optimal level. Credit management is a vital part of this process. The number of days that bills remain outstanding has a decisive impact on cash flow. Nearly one-third of business failures are due to delays in payment. It can be argued that revenue generation is the most critical function of a company. Companies that created exciting new products but failed to generate significant revenue burned through their cash and ceased operating. Every company expends substantial resources to generate increasing levels of revenue. However, that revenue must be converted into cash. Cash is the lifeblood of any company. Therefore, the staff and processes that manage receivables asset:
- Manage 100% of company's revenue
- Serve as a service touch point for virtually all your customers (Only Sales and Customer Service speak more with customers)
- Can incur or save millions of Rupees of bad debt and interest expense
- Can injure or enhance customer service and satisfaction leading to increases or decreases in revenue.
The benefits of effectively managing the receivables asset are:
- Increased cash flow
- Higher credit sales and margins
- Reduced bad debt loss
- Lower administrative cost in the entire revenue cycle
- Decreased deductions and concessions losses
- Enhanced customer service
- Decreased administrative burden on sales force
- These benefits can easily total millions in profit and tens of millions of cash flow in a year.
Mapping of Accounts Receivables
- The first step in the process flow on receipt of customer order is the creation of the Project. The creation of a project enables tracking of equipment costs and is used for internal referencing.
- The sales order once received is recorded in the ERP system.
- The advance payment if any is received and recorded at a customer level in the system.
- The nature of business activity of HED is such that the sales orders are of very high order values and involve manufacturing of long lead industrial equipment. Due to this, the payment terms of sales orders are mostly based on progress milestones. Hence the invoices are raised based on milestones achieved and final commercial invoice on the delivery of goods.
- Payments are received from customers against the invoices raised.
- The cash flow projection statement and the outstanding payments statement is updated based on the invoicing done and the payments received.
Typical Nature of Receivables at L&T, HED
Before commencement of work on a highly engineered good which has a long lead cycle time of production, it is vital to receive guarantee of some nature for acceptance of delivery by the customer. This is ensured through higher proportion of advance payments which contributes towards bringing down the working capital needs for the company in order to execute the particular order.
A typical example of payment terms for a sales order is 5 - 10 - 15 - 20 - 45 - 5.
5% Advance Payment
10% Milestone I
15% Milestone II
20% Milestone III
45% Against dispatch
5% against successful commissioning.
It can be seen from the above mentioned example that before the actual dispatch of goods, almost 70% of the payment is recovered from the customers (The actual recovery % differs from order to order). By the time the material is dispatched, most of the costs incurred on the equipment / component are usually recovered through progress payments. Thus, the outstanding payment after delivery of the component has a comparatively low percentage value wise. This includes the payment on successful commissioning of material or against some performance clause. The usual retention percentage ranges between 5 & 10%. The time required to get the balance payments may vary depending upon, again the payment terms of the Sales order and the customer profile. The time period required for the final payment against performance may be high depending upon a lot of external factors.
Alternatives available for Working Capital Financing:
An exporter may need financial assistance for execution of an Export order from the date of receipt of an export order till the date of realization of the export proceeds at any stage. “Pre-shipment /packing credit” means any loan or advance granted or any other credit provided by a bank to an exporter for financing the purchase, processing, manufacturing or packing of goods prior to shipment, on the basis of letter of credit opened in his favor of some other person, by an overseas buyer.
Types of Pre-Shipment Credit:-
Clean Packing Credit: This represents an advance made to the exporter on the basis of a firm export order or a letter of credit, without any control over raw materials or goods. Each proposal is decided on the basis of particular requirements of the trade and the creditworthiness of the exporter. A suitable margin is maintained.
Packing Credit against Pledge of goods: Under this arrangement, the goods meant for export are pledged to the bank with an arrangement with an approved clearing agent who ships the same on the advice of the exporter. The goods pledged with the bank lie in its possession. Since 1993, the RBI has been permitting exporters to avail of pre-shipment finance denominated in foreign currency arranged by a domestic bank. The bank funds itself in the EURO market and on lends the funds to the borrower at a margin not exceeding 2% over its own borrowing cost. The loan has to be repaid out of the export proceeds. Depending upon the level of interest rates in the Euro market and the ruling premier on the foreign currency, this may work to be cheaper than pre-shipment finance in rupees.
Packing Credit against Hypothecation of Goods: Under this arrangement, the goods meant for export are hypothecated to the bank as security. When the bank advances is to be utilized, the exporter is required to furnish stock statements and continue to do so whenever there is stock movement.
It means any loan or advance granted or any other credit provided by a bank to an exporter of goods from India from the date of shipment of goods to the date of realization of export proceeds and includes any loan or advance granted to an exporter in consideration of, or on the security of any duty drawback allowed by the government from time to time.
Types of Post-Shipment Finance:
Purchase / discounting of documentary export bills: A commercial bank may purchase export bills payable at sight or discount usance export bills covering sales and supported by relevant documents like the bill of lading, post parcel receipts, etc. The bank, when it provides in this way requires:
- A letter of hypothecation covering the goods.
- A general guarantee by the directors or partners of the firm as the case may be.
- A comprehensive risk covers by the Export Credit guarantee Corporation.
Advances against export bills sent for collection: A commercial bank may provide finance by way of advance against export bills forwarded through it for collection after. Taking in to account the creditworthiness of the party, nature of goods exported usance etc. The documents required by the bank for such advance are :
- A demand promissory note
- A letter of continuity
- A letter of hypothecation covering bills
- A general guarantee of directors or partners of the firm, as the case may be
Advances against exports on consignment basis: Goods are exported on consignment basis at the risk of the exporter for sale abroad, eventual remittance of sale proceeds will be made by agent or consignee. The overseas branch will be instructed to deliver the documents against Trust Receipt Advances granted against the export bill-covering goods sent on consignment basis would be liquidated from remittance of the sale proceeds within 6 months from the date of shipment.
Advances against undrawn balance: In certain line of export trade, it is the practice of the exporter to leave a part of the amount as undrawn balance. The buyer for difference in weight will make adjustment, quality etc. ascertained after arrival and inspection or analysis of the goods. Advance against undrawn balance can be made at a concessive rate of interest for a maximum period of 90 days.
Advance against Duty drawback, Cash subsidy: To help exporters banks advance against duty drawbacks, cash subsidy etc, receivable by exporters against their exports. Since such advances are clean in nature, the bank providing finance in this way generally insists that the relative export bills are either negotiated or forwarded for collection through it so that it can verify the exporters claim for duty drawback, cash subsidy etc. Such advance, short-term in nature, is repayable within 180 days from the date of shipment of goods
Conclusions / Recommendations On The Basis Of Study Of Receivables Management
We can see from the ratio analysis conducted for the working capital ratios that the performance of L&T, HED in terms of debtor's turnover is on the higher side with respect to its competitors. Thus the debtor's collection period for L&T, HED is one of the lowest and the best in the Industry, when compared with Indian as well as foreign competitors.
Due to the nature of clientele, which is mostly government undertaking bodies, the payments are delayed as compared to other customers, but this number is fairly low.
As per the present situation, availability of funds for financing working capital is not a matter of concern for the Heavy Engineering Division and for Larsen & Toubro as a whole. Thus, the various other sources of financing receivables and enhancing actual cash flows are not being looked into in detail. However, if the need may arise in future, there are possibilities of availing financing for working capital through alternative sources such as Receivables factoring for domestic and International Sales. These services are being offered in India by many factoring houses / Banks.
Study Of Payables Management At Heavy Engineering Division
Role of Purchase Department in an Organization
The purchase department carries out the activity of purchasing of goods and supplies across the organization. In most of the companies, sourcing is inextricably linked to success. A typical purchase department influences 50 to 80% of a company's cost structure. Moreover, the activity of providing everything a company needs, makes the wheels go around. The purchase department is absolutely critical to an organization's ability to execute its strategies.
Role of the Purchase Department of L&T HED - Some salient features of the Purchase Department of Heavy Engineering Division are:
- The Heavy Engineering Division consists of a number of Strategic Business Units depending upon the nature of clientele it serves. The purchase process for all Strategic Business Units (SBU's) is a de-centralized process - the various SBU's of HED (FPEX, RCOG, CGPP, Defense, Nuclear etc) carry out their own respective purchases for raw materials, equipment, consumables etc.
- There is also a Central purchase cell which handles purchases which are not taken care of by the respective SBU purchase departments. These purchases include materials like welding consumables, factory operating supplies, Service contracts etc.
Purchase Process Mapping at L&T HED:
In spite of a de - centralized Purchase Process for the various Strategic Business Units in L&T, HED, a more or less fixed Purchase process is followed throughout. The figure below gives a brief idea about the same which is followed by an explanation:
1. The Purchase requisition is received from the user / production department which gives the technical details of the material to be procured.
2. Based on the Purchase requisition, request for quotations are floated to suppliers. The suppliers are usually from the preferred supplier list. Exceptions are allowed in case of unique and exclusive material supplies.
3. After the receipt of quotations / bids from suppliers, a technical and commercial evaluation follows. This is usually coupled with discussions regarding the same.
4. The order is placed and an order entry is made.
5. The material is received from the supplier along with the Delivery challan and the commercial invoice.
6. The Goods receipt Note (GRN) is prepared after receipt of material.
7. The goods are inspected for conformity with respect to quality and quantity as per the purchase order. The approved GRN is available for the Finance department for further processing of payments. The above information is used in the 3 way matching process by the finance department and the payment is released. Payment release leads to closure of order and updating of records in the system.
Conclusions / Recommendations On The Basis Of Study Of Payables Management
The performance of L&T, HED with respect to credit period availed against fixed can be considered at par with the standards it has set for itself. However, an organization should always strive to reach the unreachable. Some of the suggestions which can serve in improving the performance of Payables have been depicted below:
1. Centralized Purchase Department
The Heavy Engineering Division of L&T has been further divided into number of Strategic Business Units viz. FPEX, CGPP, RCOG, WSAS, NUCL etc. The purchasing activity for each SBU is a de-centralized process which is undertaken on an SBU level. Hence there are different personnel handling different SBU purchases. Although there are informal purchase forums wherein the prices, delivery terms and credit terms decided upon with different suppliers are discussed in detail and strategies are evolved, a centralized approach to purchase may resolve some of the technical problems faced. Some of them have been elaborated below:
- Supplier Consolidation - this activity which has been taken up on an SBU basis can also be conducted on a divisional basis (internal source). This will be possible if a formal system exists in order to monitor the centralized data. Through supplier consolidation on a divisional basis, better results may be obtained which will result in bringing down the transaction costs and risk associated with handling too many suppliers.
Supplier consolidation is a double edged sword which needs to be handled carefully. As the number of suppliers is reduced, risk increases. In order to mitigate such risks, relationships with suppliers gains top priority. Active management of the supplier relationship reduces costs from Ad-Hoc approach. Hence domain expertise is required to implement the above strategy which should be entrusted to responsible personnel in the organization.
- Better terms - Having a centralized purchase department will also help in monitoring the purchase order terms fixed by different SBU's. Although in most cases, the terms (especially credit terms) are of standard nature, there is a possibility of a supplier finalizing different terms for purchase orders of different SBU's. This chance can be eliminated by having a centralized authority for purchase department.
Besides these, some of the other advantages of a centralized purchase department are :
- i. Focus on overall corporate strategy.
- ii. Leverage the company brand and stature.
- iii. Tighter control of purchasing policies and procedures
- iv. Business units to focus on their core competencies
- v. Consolidate buying volume for greater negotiating power and lower costs
- vi. Reports to a higher level, giving purchasing greater muscle within organization
2. Credit Period Extension
The importance of stretching the creditor's deferral period cannot be undermined. Hence, care needs to be taken that in all the cases of supplier payment, credit needs to be availed to the fullest. Also, further credit extension techniques need to be evolved in order to decrease the working capital needs at HED.
By employing the above two techniques of centralized purchase department and consolidation of supplier base, it will be possible to reduce the number of suppliers and the management of the same will become easier. Consolidation of supplier base will mean higher order worth per supplier. A guarantee of placement of order upon a supplier should encourage the supplier to accept credit terms which are higher than usual. Also, a win - win situation is possible through encouraging more number of suppliers to extend credit period and having a discounting (Hundi) option at their disposal. More number of suppliers availing the discounting facility will also
mean better discounting rates than the prevailing rates from banks.
3. Vendor Grouping and Categorization:
Every firm's goal is to hold onto cash as long as possible, without incurring interest charges or penalties, damaging credit or service relationships, or affecting the firm's business reputation. This means deciding when to pay early, when to pay on time, and when it is acceptable to pay late. The answer to when to pay late can be determined by categorizing vendors and treating them according to their relative importance to the firm. The answer to How late can a supplier be paid is usually best discovered experimentally.
A sample categorization is listed below. There are a variety of other factors one might include in a vendor categorization system, depending on what is considered important about relationships with vendors. However, not all vendors are created equal. Some vendors are more important than others.
- Critical: Vendor supplies materials or services that cannot be obtained from any other source. Vendor maintains a unique or personal relationship with your firm that merits special consideration.
- High: Supplier is a member of a professional association or provides credit information to others. Finance charges and penalties for late payment are assessed and enforced. There are high transaction costs associated with switching to another vendor.
- Moderate: Penalties or finance charges for late payment are assessed but enforced irregularly or not at all. There is a receipt of reminder from the supplier but no finance charges or penalties are usually imposed or enforced up to the outer limit. There is a relatively low transaction cost associated with switching vendors or this vendor is assured for other legal or contractual reasons.
- Low: No finance charges or penalties are assessed for late payment. There is never a payment reminder from the supplier. Many alternative sources of supply are available with the same or similar quality, pricing, and service. No or very low transaction costs are associated with switching. The products or services provided by this vendor are not of critical importance to the operation of the firm.
4. Futures Contracting
What is future's contracting
Futures markets and forward markets trade contracts determine a current price for a commodity transaction designated to take place at a later date. A futures contract is a specialized form of forward contract that is standardized and traded on a futures exchange. Futures contracts are standardized contracts where the quantity, quality, date of maturity and place of delivery are all standardized and the parties to the contract only decide on the price and the number of units to be traded. Futures contracts are entered into through the Commodity Exchanges and are regulated by the provisions of the FC(R) Act. Forward contracts are contracts for supply of
goods and payment where supply of goods or payment or both take place after 11 days from the date of contract or where delivery of goods is totally dispensed with. A significant difference between futures and forward contracts arises because futures contracts are legally required to be traded on futures exchanges while forwards are usually created by individual parties operating in the decentralized OTC markets. To facilitate exchange trading, futures contracts possess a number of key features, especially standardization and marking to market. The elements of standardization provided by the futures contract and by the rules and regulations of the exchange governing such contracts involve: the deliverable grade of the commodity; the quantity deliverable per contract; the range of quality within which delivery is permissible; the delivery months; and, the options associated with the specific grade and date of delivery that is permissible. Standardization is achieved by making each futures contract for a given commodity identical to all other contracts except for price and the delivery month. In addition to standardization, forwards and futures also differ in how changes in the value of the contract over time are handled. For futures, daily settlement, also known as marking to market, is required. In effect, a new futures contract is written at the start of every trading day with all gains or losses settled through a margin account at the end of trading for that day. This method of accounting requires the posting of a "good faith" initial margin deposit combined with an understanding that, if the value in the margin account falls below a maintenance margin amount, funds will be transferred into the account to prevent the contract from being closed out. On the other hand, settlement on forward contracts usually occurs by delivery of the commodity at the maturity of the contract. Hence, futures contracts have cash flow implications during the life of the contract while forwards usually do not.
Why consider futures contracting at L&T HED
After conducting a detailed analysis on the materials procured by L&T from Prowess data, it was noted that steel purchases occupy a major proportion of the total purchases. The prices of steel are volatile in nature depending upon the international market scenario.
Why involve in Steel Futures
A. Wide Price Variation
The domestic steel prices show high variation on a monthly basis. The instability in domestic prices is mainly derived from the wide variation in international steel prices and the imported steel prices.
B. No Government Restrictions
The domestic steel industry was de-licensed and decontrolled in early 1990's. The price regulation is also abolished and as such the Government has no control over prices. The Government has also considerably brought down the customs duty and excise duty in the last few years.
C. Large Number Of Small And Marginal Players In Private And Unorganized Sector
With the liberalized Government policy in place, more number of private players is expected to enter, participate and grow in the steel industry in the coming days, resulting in higher demand for right pricing based on indicative markets. Thus there are a whole lot of producers and buyers in the production and supply chain whose business is hugely dependent on the right price discovery of the commodity.
D. Buoyant Domestic Industry And Its International Linkages
In India the domestic demand and exports are in a rising trend since the last couple of years. The Indian industry also imports specialized steel as the domestic manufacturers are more comfortable in producing construction steel. Thus there are high linkages with international markets.
E. Standardized Quality
In the presence of IS Grades the commodity steel can be reasonably standardized in the form of long (ingots) and flat (coil).
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Larsen & Toubro Limited and Heavy Engineering Division Annual Reports
http://www.ltindia.com/ - Information on L&T
Purchase Knowledge portal of L&T, HED
Internal reports generated through BAAN (ERP for Finance & Accounts, Purchase and
CMIE database - Prowess - Annual Reports of Bharat Heavy
Electrical Limited, Andhra Pradesh Heavy Engineering & Machinery Limited,
Walchandnagar Industries Limited and Godrej & Boyce Mfg Co.
http://www.hitachizosen.co.jp - Annual Reports of Hitachi Zonsen
http://www.seriworld.org - Korea Information Service website - Annual reports of
Daekyung Machinery & Engineering & Doosan Heavy Ind. & Const
http://www.lme.co.uk/ - London Metal Exchange Homepage for prices of steel and
IBS-Working capital management at L&TPage 39