As part of its restructuring of Air India, the Government of India intends to convert it into a low cost airline. While this proposal has merits, Air India needs to utilise the benefits that come from its large size to succeed as a low-cost carrier. Size offers an important advantage in the Airline business because efficient airlines typically operate a ?negative working capital business.?
An example of the importance of working capital management was the mid-2000 decline of Amazon.com?s stock price. In June 2000, several analysts issued a stern warning about Amazon.com?s ?poor working capital management and the resulting negative cash flows.? Within days, the company?s stock, which had reached a 52-week high prior to the warning, plummeted more than two-thirds. Post mortems attributed this to poor working capital management practices.
A firm?s working capital, that is, the capital it needs to continue its business smoothly, is comprised mainly of three components: (i) accounts receivables; (ii) inventory; and (iii) accounts payables. When a firm sells to its customer on credit, it accumulates account receivables. In other words, accounts receivables denote the cash yet to be paid by a customer for a sale that has already occurred. Similarly, when the company purchases from its suppliers on credit, it accumulates accounts payables. A company?s working capital requirements increase with increases in accounts receivables but decrease with increases in accounts payables.
Now consider an airline company. When you purchase an airline ticket on the internet, you pay cash in advance before traveling. Therefore, the airline receives cash first and then provides the service, which makes its accounts receivable negative in this instance. However, airlines can avail the benefit of accumulating accounts payable by receiving credit from their suppliers. Since their accounts receivables are negative and their accounts payables are positive, efficient airline companies have negative working capital requirements. If managed capably, working capital feeds an airline?s business rather than the other way around. Therefore, if exploited resourcefully, size matters in the airline business?greater the actual number of customers served in a period, greater the cash accrual, which feeds back into the business. Given Air India?s size, well-organised working capital management practices can generate significant cash and feed its business.
Research on airline companies highlights that competent working capital management is a critical success factor for airlines. Good working capital management not only drives balance sheet strength?an essential element in determining an airline?s credit position?but also revenue, expenditure, cash flow and most importantly, customer service. In 2004, when it was bailed out by the Italian government, net working capital in Alitalia locked up financial resources equivalent to an astonishing 8.1% of sales. In contrast, Ryanair, a successful, low-cost European carrier, ran a very tight ship with negative working capital of minus 2.8 % of sales.
What are the constraints to proficient working capital management and what are the areas that provide Air India opportunities for improvement? A key challenge is that the timing of cash-flows is determined by standard industry clearing house practices. For example, as per International Air Transportation Association (IATA) standards, inter-airline settlement of passenger sales (that accrue as part of airlines? alliance agreements) is processed on a monthly basis with a 19-day settlement period. Similarly, inter-airlines cargo business is settled on a monthly basis with a 31-day settlement period. Sales done through travel agencies are typically settled within a fortnight.
Given these delays in revenue generated through alliances, Air India should formulate a strategy to generate a significant proportion of its revenues outside of these clearing systems. A user-friendly and effective internet-based ticketing system offers the potential to generate direct sales, which will not be subject to these delays in cash realisation. While Alitalia had a Days Sales Outstanding (DSO) of 52 days, Southwest Airlines, a successful low-cost airline, uses internet-based booking to achieve a DSO of minus six days. In other words, subsequent to flying a customer, Alitalia would get cash almost two months later. With effective internet based sales, in contrast, Southwest would receive cash six days before its customer flies.
Apart from relying more on web-based sales, delays stemming from the settlement systems can be reduced too. If transactions are not readied in time prior to the monthly settlement slots, claims submission would be delayed for up to a month. As a result, accounts receivables and thereby working capital levels would spiral. Therefore, streamlining internal receivables management procedures can lead to substantial savings.
Air India can realise huge savings from efficient working capital management. The receivable balance of a large airline typically exceeds $1.5 billion. Thus, a 20% reduction in these receivable balances can generate additional cash of $300 million.
The author is an assistant professor of finance at Emory University, Atlanta, and a visiting scholar at the Indian School of Business, Hyderabad