BBC PVT. LTD. AND WORKING CAPITAL CHALLENGES - CASE STUDY

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BBC PVT. LTD. AND WORKING CAPITAL CHALLENGES Nimisha Kapoor and Professor Sandeep Goel wrote this case solely to provide material for class discussion. The authors do not intend to illustrate either effective or ineffective handling of a managerial situation. The authors may have disguised certain names and other identifying information to protect confidentiality. This publication may not be transmitted, photocopied, digitized, or otherwise reproduced in any form or by any means without the permission of the copyright holder. Reproduction of this material is not covered under authorization by any reproduction rights organization. To order copies or request permission to reproduce materials, contact Ivey Publishing, Ivey Business School, Western University, London, Ontario, Canada, N6G 0N1; (t) 519.661.3208; (e) [email protected]; www.iveycases.com. Copyright © 2012, Richard Ivey School of Business Foundation Version: 2017-05-30

In January 2012, Arpit Agarwal, managing director of chemical manufacturing company BBC Pvt. Ltd., was contemplating the alternatives that he could explore before the company proceeded with its plan to sign a contract with Indian Railways (IR). Agarwal had been a leading member of BBC since its beginnings in 2004. BBC now had an advance acceptance document confirming its contract with IR, yet the company was suffering from a lack of working capital due to a combination of extending liberal credit to its customers and repaying debts too quickly. Therefore, Agarwal was not sure what the company’s next step should be. BBC BBC Pvt. Ltd. was an Indian chemical manufacturing company established in 2004. The company’s registered office was in Bangalore and its manufacturing plant was in Lucknow. BBC was managed by two directors, Agarwal and Mukesh Kumar. Kumar was a science graduate and Agarwal had a degree in management. BBC was categorized as a small-scale industry under the domain of chemical manufacturing. It produced and sold stable bleaching powder using the raw material liquid chlorine. Since both the raw material and the end product were highly toxic BBC was also classified as a hazardous industry.1 A license from the Government of India’s Department of Industrial Policy & Promotion was required in order to store the cylinders of liquid chlorine. The company usually procured its raw material from the Sonebhadra district in Uttar Pradesh. The price of this raw material could fluctuate wildly, from as low as INR10 per tonne to as high as INR10,000 per tonne. This wide price range was based upon suppliers’ capacity to store and sell liquid chlorine within the limitations of licensed quantities. Any raw material exceeding these licensed quantities had to be sold at lower a price.

1 According to the Environment (Protection) Act, 1986 any industry handling or dealing with hazardous substance which may cause adverse effects on the health of the people and the environment may be put under the category of hazardous industry. Thus, industries relating to the products of chemicals petroleum fertilizer, leather highly inflammable liquid gases etc. can be classified as hazardous industries. The Environment (Protection) Act, 1986, Ministry of Environment and Forests, www.envfor.nic.in/legis/env/eprotect_act_1986.pdf, accessed November 15, 2012.

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Page 2 9B12N026 Stable bleaching powder could be manufactured through one of two techniques: absorption or adsorption. The product manufactured by the absorption technique was of better quality than the product manufactured by the adsorption technique. BBC used adsorption, which meant that its product was of an inferior quality compared to the products of its competitors. The company’s main competitors were industry giants like the Aditya Birla Group, the DCM Group, Grasim Industries Limited, etc.; however, these companies were also BBC’s suppliers of liquid chlorine. Because of the more affordable (but lower quality) adsorption technique used in production, BBC was able to reduce its operating costs with respect to installation of equipment, maintenance and electricity expenditure. Despite producing a bleaching powder of inferior quality, the use of adsorption allowed the company to enjoy a favourable market share due to the cost advantage BBC was able to pass on to its customers. BBC’s customers could be divided into two broad categories: government accounts and private accounts. The government placed orders whenever there was a demand in any of its departments. Private contracts were negotiated according to industry factors such as the reputation/standing of the involved party, past dealings, size of the order, etc. Orders from private customers were usually smaller than government orders and the BBC’s customer base was largely comprised of private accounts. The company enjoyed a credible position with its bankers. Its main bank was Union Bank of India, a nationalized bank. BBC had a cash credit limit of INR2.5 million, which had been fully utilized. During a meeting with the bank manager regarding the IR contract, Agarwal could sense the manager’s reluctance to extend a fresh line of credit to BBC. The bank manager mentioned that the interest on the loan required to complete the contract with IR would be 14.5 per cent; the offer was against a pledge of share certificates for an existing loan with the bank, in light of the fact that BBC was carrying existing unsecured loans that resulted in interest payments of more than INR600,000 annually. WORKING CAPITAL MANAGEMENT BBC had been following a conservative approach to working capital, as reflected in its high level of net working capital — more than INR4.2 million in fiscal year 2010/11 (see Exhibit 1). The net working capital of the company had always remained positive, as reflected in its balance sheet (see Exhibit 1). BBC’s assets were more than 10 times its liabilities. These assets were mostly in the form of inventories and accounts receivable. However, trade credit of the firm had become a major liability. The company’s management had been very conservative and traditional with respect to repaying loans before the credit period; from 2009 to 2011, BBC’s liquid-asset-to-total-asset ratio ranged between 62 and 66 per cent — whereas the industry benchmark was 30 per cent. BBC’s inventory could be categorized into three groups: raw materials, finished goods and packing materials. From 2009 to 2011, inventory in all three of these categories had risen significantly, increasing the total inventory by almost 85 per cent. Raw material and packing material were valued at cost on a first- in-first-out (FIFO) basis. Finished goods were valued at cost or at net realizable value — whichever was less. Although such high levels of inventory eliminated the possibility of disruptions in manufacturing due to a stockout, it had led to wastage of BBC’s working capital. A large stock of finished product stored in the company’s premises had long been a cause of concern for Agarwal (see Exhibit 2). He knew that the company’s sales had gradually decreased. Immediate action was required as decreased sales would negatively affect the profitability of the company and BBC’s return on capital employed in the future.

Page 3 9B12N026 BBC’s debtors had remained more or constant with minor fluctuations. The credit periods on the loans ranged from 15 days to almost two years. The largest amount due on a single account was INR4 million. Debtors/receivables turnover ratio of the company had ranged from 2.9 to 3.2 times for the last three financial years. Despite this, BBC continued to extend liberal credit to new accounts. The company had been maintaining adequate levels of cash but these levels would not be sufficient for additional orders like the proposed contract with IR. The cash and bank balance in BBC’s balance sheet was inclusive of a fixed deposit maintained with the bank. The company also indulged in future commodity trading. The profits from these activities were apparent in BBC’s profit and loss statement (see Exhibit 3). BBC had been too quick in paying back its creditors. This had affected the company’s liquidity: the longer the repayment period, the lower the net present value of the payment and the higher the value to the firm. The company also maintained a cash credit limit of INR2.5 million with Union Bank of India. THE CONTRACT WITH INDIAN RAILWAYS Operations were running relatively smoothly at BBC but Agarwal knew that there was an urgent need to upgrade the company in order to make it a truly competitive market player. The IR contract could prove to be such an upgrade, and it had therefore been an aspiration of Agarwal’s since 2011. He had registered his company for all three divisions of Indian Railways in the northern part of India (Northern Railways, North Eastern Railways and North Central Railways). This contract would open the gates between BBC and IR for long-term business, and could potentially act as a stepping stone for BBC to become the preferred supplier of bleaching powder for other big players in the industry as well; however, the contract would be a challenge and would require a professional team working to make BBC eligible. Agarwal desperately needed a manager who could handle the administration and official correspondence of this account efficiently, as well as monitor operations along with the floor supervisor. As part of the contract, IR was demanding an onsite office, a warehouse and a workshop within the BBC factory premises. In addition, the document of advance acceptance clearly outlined proposed quarterly onsite inspections. These inspections would have to be conducted at the factory premises before any lot was dispatched to IR. Furthermore, establishing an onsite IR office would cost a onetime expenditure of approximately INR200,000, as well as an increase in administrative costs. The company had to put its stock in a new warehouse as part of the proposed contract. As of January 2012, BBC did not have any warehouse that met the required safety norms. All materials, including spare parts, raw material, packaging material and finished products, were kept in a semi-covered storage area within the factory premises; this often led to losses due to deterioration in the quality of material. The approximate cost of building a new warehouse would be INR500,000. There was also an urgent need to create a separate workshop within the factory for safety and maintenance. Since BBC’s manufacturing process involved various hazardous chemicals, maintenance of the existing machinery was a crucial activity. The workshop could be used to repair rusted or worn-out machine parts that were employed in the manufacturing. Certain critical parts had to be repaired regularly. Having a separate workshop exclusively for such activities would be very helpful in daily operations of the factory. The company estimated an expenditure of approximately INR500,000 for establishing such a workshop. Above all, BBC needed to maintain adequate cash reserves to meet all of its payments and continue its usual production activities without any interruption. The total amount required for the upgrade — INR1.2 million — was beginning to worry Agarwal. BBC had already reached its cash credit limit of INR2.5 million and its recoverables were blocked in the form of either inventories or receivables. In financial year

Page 4 9B12N026 2010/11, the company had to pay more than INR640,000 in financial charges and interest. Agarwal regretted his previous decision to avoid putting BBC’s money in short-term investments, which could have been a source of funding for the upgrade that the IR contract would require. Retrospectively, he realized that BBC had been shortsighted in extending liberal credit to its customers and being more prompt in repaying debts than business demanded. THE WAY FORWARD BBC was able to attain many orders and manufacture its product at a cost much lower than its competitors; this fact reassured Agarwal, although he knew that there were issues that needed immediate action. Agarwal was aware that BBC’s gross block was continuously decreasing and the company was therefore shrinking — rather than growing — at a rapid rate. Agarwal knew that in order to complete the contract with IR, BBC would require a significant upgrade by December 2012. How could the finances required for this upgrade be secured? Should Agarwal seek to improve BBC’s working capital management or pursue complete financial policy restructuring?

Nimisha Kapoor and Professor Sandeep Goel are from MDI, Gurgaon, India.

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Exhibit 1

BBC BALANCE SHEET — 2009-2011

2011 2010 2009 Sources of funds Shareholders funds Share capital 950,000 950,000 950,000 Reserve & surplus 439,990 370,841 307,736 Loan Fund Secured loan 180,345 1,284,237 1,237,475 Unsecured loan 5,018,221 4,603,476 4,223,011 Total 6,588,557 7,208,556 6,718,222 Application of Funds Fixed assets Gross Block 2,621,861 2,944,618 3,103,368 Less: Depreciation 270,798 324,757 355,292 Net Block 2,351,064 2,619,861 2,748,076 Assets, Loans & Advances Inventories 870,146 740,749 322,848 Sundry debtors 2,948,850 2,936,732 3,355,773 Cash & Bank Balance 453,079 815,640 554,800 Loans & Advances 252,199 356,636 272,211 Total 4,524,274 4,849,757 4,505,632 Less: Liabilities Liabilities 130,166 135,348 363,486 Provisions 156,615 125,715 172,000 Total 286,781 261,063 535,486 Net Assets 4,237,493 4,588,694 4,047,146 Total 6,588,557 7,208,556 6,718,222

Source: BBC Pvt. annual reports, 2009-2011.

Exhibit 2

VALUATION OF INVENTORIES — 2009-2011

2011 2010 2009 Inventories 870,146.2 740,749 322,848 Raw Materials 432,071 166,573 149,924 Packing Material 85,915.2 87,976 5,624 Finished Goods 352,160 486,200 167,300

Source: BBC Pvt. annual reports, 2009-2011.

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Exhibit 3

BBC PROFIT AND LOSS STATEMENT — 2009-2011

2011 2010 2009 Income Sales 9,544,409 8,529,838 12,539,108 Other income 602,873 176,603 250,296 Increase/ Decrease in Stock -134,040 335,549 -133,827 Total 10,013,242 9,041,991 1,265,577 Expenditure Raw Material Consumed 4,982,486 3,412,916 5,340,943 Manufacturing Expenses 3,434,866 3,699,344 4,765,355 Directors Remuneration 360,000 432,000 360,000 Other Expenses 223,791 451,052 935,404 Depreciation 270,798 324,757 355,292 Interest & Finance Charges 641,252 628,315 674,905 Total 9,913,194 8,948,385 12,431,899 Profit Before Tax 100,048 93,605 223,676 Profit After Tax Add: Transfer from previous year Balance Sheet

370,841 307,736 163,044

Provision for Income Tax 30,900 30,500 57,000 Balance carried to Balance Sheet 439,990 370,841 307,736

Source: BBC Pvt. annual reports, 2009-2011.