Case 012Portfolio operations and exitsCore

A pharma distributor's operating team proposes a working capital programme: receivables from 75 to 60 days, inventory 60 to 50, payables 45 to 50. How much cash is released, and what does it do to the IRR on Rs 300 crore of equity?

The situation

Kirtiman Pharma Distributors buys medicines from manufacturers and supplies chemists and hospitals across four states. Revenue is Rs 1,460 crore and cost of goods sold Rs 1,168 crore, so Rs 4 crore of sales and Rs 3.2 crore of cost pass through every day. Customers pay in 75 days on average, stock sits for 60 days, and suppliers are paid in 45 days.

The fund put in Rs 300 crore of equity a year ago and the base plan returns 2.5x at the end of year 5. Debt costs 10%. The operating team believes it can bring receivables to 60 days with collection discipline, inventory to 50 days with better ordering, and payables to 50 days by consolidating suppliers.

Your task

Compute the cash released by each lever and in total, then show the effect on MOIC and IRR if the release happens in year 1 against year 5. Say what the programme does and does not do.

Quick check

Payables are measured on cost of goods sold, receivables on revenue. What happens if you compute the payables release on revenue instead?

Worked solution

Try it on paper, then open one step at a time.

30-second answerThe answer to give first

The programme releases Rs 108 crore once: Rs 60 crore from receivables, Rs 32 crore from inventory and Rs 16 crore from payables, cutting the cash cycle from 90 to 60 days. Released in year 1 and used to repay 10% debt it is worth Rs 158 crore at exit, lifting 2.5x to 3.03x and the IRR from 20.1% to 24.8%; released in year 5 it adds only Rs 108 crore and 23.4%. It does nothing for EBITDA, so nothing for the exit multiple.

Step 1How much cash does each lever release?

Working capital is money sitting in the gaps between paying and being paid. A kirana shop that gives customers a month's credit while paying its wholesaler on delivery has its own cash parked in those accounts; shorten the credit by a week and that week's sales come back as cash, once. The arithmetic is days times the daily flow, and the flow is revenue for receivables but cost of goods sold for inventory and payables. Receivables: Rs 1,460 crore over 365 is Rs 4 crore a day, and 15 fewer days is Rs 60 crore. Inventory: Rs 3.2 crore a day, 10 fewer days, Rs 32 crore. Payables: 5 more days of Rs 3.2 crore, Rs 16 crore of supplier money the company now holds.

LeverDays beforeDays afterBalance before, Rs croreBalance afterCash released
Receivables (DSO, on revenue)7560300.0240.060.0
Inventory (DIO, on COGS)6050192.0160.032.0
Payables (DPO, on COGS)4550144.0160.016.0
Net working capital90 day cycle60 day cycle348.0240.0108.0
Receivables and inventory fall and payables rise, so net working capital drops from Rs 348 crore to Rs 240 crore and Rs 108 crore of cash comes back to the company in the year the programme lands.
Cash conversion cycle before and after, days, and the rupees each lever releasesBefore90 daysRs 348 crore tied upReceivables 75 daysInventory 60Payables 45 daysCycle ends: day 90After60 daysRs 240 crore tied upReceivables 60 daysInventory 50Payables 50 daysCycle ends: day 600306090120Days from paying for stock to being paid by the customerReleased: receivables 60 + inventory 32 + payables 16 = Rs 108 crore, once
The cash conversion cycle shortens from 90 days to 60 days as receivables drop 15 days, inventory 10 days and payables stretch 5 days, releasing Rs 60, Rs 32 and Rs 16 crore, Rs 108 crore in total.
Step 2What does Rs 108 crore do to the return, and why does timing matter?

The base plan turns Rs 300 crore into Rs 750 crore, 2.5x and 20.1% a year. If the Rs 108 crore arrives in year 1 and repays 10% debt, it saves four years of interest and is worth Rs 158 crore of extra equity at exit; the same release in year 5 is worth Rs 108 crore. Year 1: Rs 908 crore over Rs 300 crore is 3.03x, an IRR of 24.8%. Year 5: 2.86x and 23.4%. The programme is the same; the four years of compounding are the difference.

The relationship
Value at exit=108×(1.10)4=158IRR=(750+158300)1/5−1=24.8%\text{Value at exit} = 108 \times (1.10)^4 = 158 \qquad \text{IRR} = \left(\frac{750 + 158}{300}\right)^{1/5} - 1 = 24.8\%
108cash released by the programme, Rs crore
(1.10)^4four years of 10% debt interest avoided
750base-case exit equity before the programme
What it says in wordsRs 108 crore repaid in year 1 is worth Rs 158 crore by year 5, which takes the fund's return from 20.1% to 24.8% a year.
Step 3What does the programme not do?

It does not change EBITDA, so it does not change what the next buyer pays per rupee of earnings. Working capital is a one-time release; the following year the cycle is 60 days again and the cash from growth has to be funded at that new rate. It can also cost something: faster collection can lose a hospital that values credit, leaner stock can mean a chemist buys elsewhere when a line is out, and stretching suppliers can lose early-payment discounts worth more than 10% a year. The honest pitch to the investment committee is Rs 108 crore of deleveraging, worth about 4.7 points of IRR if done early, with the customer and supplier risks named.

Where candidates lose it

The common loss is computing all three levers on revenue. Inventory and payables are carried at cost, so the daily flow is COGS; using revenue overstates those two releases by a quarter.

The second miss is presenting the release as recurring cash flow. It is a balance sheet release that happens once; the IRR gain depends on when it lands and what the cash repays.

What the interviewer asks next

  • Revenue grows 15% next year. How much of the release does growth absorb at the new 60 day cycle?
  • Suppliers offer a 1.5% discount for paying in 30 days. Is stretching to 50 days still right?
  • What would you want to see in the monthly reporting to know the programme is holding?

Company names and figures are illustrative.