Unshackling infrastructure industry from the working capital plight

Infrastructure industry in India at the crossroads
The World Economic Forum has ranked India 71 out of 144 countries in the 2014 global competitiveness index citing poor infrastructure as one of the major reasons for this low rank. It is evident that if India aspires to be a key global player on the economic front, infrastructure development has to be taken up on a war footing. Unfortunately, even projects that have been initiated over the last few years (worth almost Rs.18 lakh crore) are stalled. Chronic delays have spiraled infrastructure companies into working capital cycles, which are among the longest in the world, putting pressure on cash flows leading to higher debt and lower returnsi. According to the finance ministry's mid-year report, private sector infrastructure companies across the board are all over indebted. Therefore, even if the incumbent government initiates new projects or expedites approval, the situation for many of these companies will continue to be dire. They may not be able to source the resources to undertake these projects. Many do not even have earnings to cover interest payments for their current debt.  Moreover, the banking sector is increasingly unable to or unwilling to lend more money to this sectorii.

Working Capital Crisis in Companies
Most of this debt is due to the high amount of working capital requirement. Even the best performing companies in this business (who have managed to have positive working capital) use 30-80% of their debt to finance working capital needs. This high working capital intensity is due to high levels of receivables and inventory. While this may be characteristic of the Infrastructure industry in India, an analysis of the major infrastructure companies over the recent years shows that there is more money stuck as receivables now than previous years (Refer to figure 1).

Figure 1: The ballooning of receivables over the years in the infrastructure industry (n=100), Source: CMIE; research @vector consulting group

The situation has deteriorated substantially with the overall external liquidity crisis. On the face of it, it looks like a problem beyond the locus of control of most companies. However a closer examination of the financials tells us that companies are not helpless – and in fact, some of this wastage in working capital is actually self-inflicted.

It can be seen that the working capital situation of infrastructure companies goes through predictable swings over the different quarters of the year. These movements are linked to how the companies recognize turnover. Skewed sales every quarter-end and greater sales skew at the end of the last quarter of the year leads to unavoidably skewed working capital requirements throughout the year. The working capital situation deteriorates dramatically in the first quarter of every year for most companies (Figure 2).

Figure 2: Erratic net working capital days of a typical infrastructure company in India; Source: research @vector consulting group

The phenomenon of last quarter (or year-end) sales spike is well documented. What is less known is that there are spikes in turnover booked at the end of each quarter as well (Figure 3).

Figure 3: Quarter end spikes of sales in a typical infrastructure company in India Source: research @vector consulting group

Each spike in sales is followed by a spike in working capital and debt. This is because while sales has been booked, and receivables have ballooned, no real money has accrued in the system from operations. It is expected that the contractor will receive payment after a credit period post billing to client. But when customer billing is batched together, this increases the risk of payment delays as errors or gaps in documentations lead to entire batch of receivables being held up. This is more so during quarter end where focus is on internal turnover booking rather than customer billing. While the contractors may cry ''delay from client end'', a substantial portion of the responsibility for this delay in realizing receivables actually lies with the companies and the way they operate.

The Turnover Bias
The sales spikes and the corresponding working capital spikes is a consequence of a ''turnover bias'' in a company's approach to project management. Turnover bias comes in when a company manipulates information or material /execution flow to meet quarter-end or year-end numbers (usually to meet targets) in its financial statements. Such cherry-picking practices are seen in most infrastructure companies –whether it is 'execution intensive' or 'material intensive'. The turnover bias manifests itself in 'material intensive' projects when managers of such organizations try to cherry-pick and supply high value items to project sites in order to meet quarter-end numbers. To do this, usually multiple work fronts are opened up in the project so that more and more high value material can be supplied and booked as sales. Since supply is usually focused on these select items, the full kit of material required to complete a logical work stretch becomes available only in fits and spurts. So work gangs move on and have to keep moving back and forth multiple times to complete work. This creates a vicious loop of wastages of time and capacity leading to delays and increased site expenses for the project (Figure 4). Similar is the case of erection intensive projects. Here too the turnover bias of the contractor makes him pick all the highest billable jobs first; which again forces him to open many work fronts to harvest more such opportunities. Without the supervisory bandwidth to simultaneously complete all these, the project is inevitably delayed.

Over time, clients have come to recognize these patterns and have become smarter. Many have now skewed the payment terms towards erection and project closure. Yet most turnover biased infrastructure companies continue their practice of ''cherry-picking'' material to meet turnover targets of quarter–end and year-end. With considerable turnover already booked at the end of the year, the opportunity to cherry-pick reduces dramatically and hence, there is a dip in the first quarter. This forces companies back to cherry-picking to meet their ambitious numbers.

Figure 4: Vicious Loop created by turnover bias Source: research @vector consulting group

The problem aggravates when recession sets in; the working capital cycle spirals out of control. New projects dry up and along with it deplete the advances possible from these projects to bank roll earlier projects. At the same time many open projects are at their tail end or near closure and a crisis-like situation is generated. Money is not available to book significant turnover, even ability to cherry-pick is gone. With no cash in hand, in order to meet ever increasing working capital requirements, the companies are pressed to source expensive short-term debt. Over time, this style of functioning drive these companies into a vicious, out of control loop of inevitably delayed projects. They are faced with angry clients, ever increasing working capital requirement, and debt (Figure 5). Thus they (already working on wafer-thin margins) have to contend with write-offs, cost over runs, erosion of profit margin, and late delivery penalties for nearly every project, sinking contractors further and further into debt.

Figure 5: Diagrammatic representation of the escalating working capital crisis of infrastructure companies over a period of time Source: research @vector consulting group

The Way Out
Breaking out of this viscous loop created by a self-destructive penchant for maximizing quarter-end turnover can only be possible if the focus shifts to flow principles – rapid execution and project closure. The flow principles can be implemented using the following rules

a) Implement a material pull system, where movement is based on the execution speed.

b) Remove value targets in purchase and focus on full kit (the complete assortment required for execution).

c) Limit the number of simultaneously open sites (work in progress limit) within a project based on availability of supervisors. And set rules to open sites only based on closures of whatever is in WIP (work in progress limit).

d) Active daily management for resolving issues obstructing flow.

These flow rules ensure that management attention is on closures. These processes successfully bring down lead-time. And the lower lead-time, in turn, inevitably leads to increased rate of turnover, taking away the need to manipulate material or information movement to secure it. The usual skew of sales turnover during quarter-end and year-end is then broken as each project is managed to meet its promised lead-time and due date. The working capital requirements and its variability will also predictably drop.

In a flow or 'closure focused' company, the realized turnover will thus improve substantially. Therefore, reorienting from ''turnover focus'' to ''closure focus'' will not only guarantee timely and within budget completion of projects, it will lead to significant release of working capital. Organizations implementing the flow principles have been able to increase the working capital turns many folds. In the process, they have also succeeded in freeing up 30-40% of their working capital. Extrapolating this to the industry as a whole indicates that Rs.30,000 crores- Rs.40,000 crores (almost 40% of the total debt of the industry) can be released by thus changing the work flow approach in projects. The impact would be availability of significant cash for investment in new projects and other avenues of growth and thereby benefiting not only the industry but the country as a whole.

1. http://www.livemint.com/Companies/Z13FJxuNfpemvD4byuiiEO/Long-working-capital-cycles-a-growing-worry.html
2. http://indiatoday.intoday.in/story/infrastructure-projects-public-funding-economy-challenges-in-2015/1/410900.html

Authors:

1) Satyashri Mohanty Director, Vector Consulting Group, a certified TOC expert and the founding Director of Vector Consulting Group - specializes in Operations and Project Management. He has about 15 years of industry and consulting experience. Satyashri has introduced and popularized TOC in Project domain of Indian industry, in various complex environments - multi-project custom manufacturing; new plant construction; plant shutdown; and new product development. Many of his clients have declared record breaking success stories in the public domain.

2) Dr.Shelja Jose Kuruvilla, Head-Research at Vector Consulting Group , completed her PhD with Birla Institute of Technology, Pilani and post- doctoral studies with Corvinus University, Budapest, Hungary. She has published over 40 research papers in national and International conferences and journals like the Journal of Retailing and Consumer Services, International Journal of Consumer studies and Journal of Retail and Leisure property. She is also a reviewer for the International Journal of Consumer Studies and Vikakpa among other journals.