In order to correctly understand the mechanics and implications of a firm’s working capital, we need to take into account a firm’s financial needs for operation, or FNOs. A firm’s FNOs are the level of operating investment needed for the company to operate its business. This investment can be financed using working capital and/or short-term financial debt. Because a firm’s working capital and FNOs are interconnected, use of only one of them in isolation will usually lead the manager astray. Indeed, decisions regarding the mix of working capital and short-term financial debt are among the firm’s important strategic, or long-term, business decisions.
A firm’s excess operating investment, which is the remaining financial capital needed to sustain the operation of the firm after taking into account its short-term operating liabilities, is referred to as its financial needs for operation (FNOs). This post briefly discusses some of the main factors that influence FNOs. Follow on…
Formally, FNOs are defined as: Current Assets minus Shortterm Operating Liabilities. This definition implies that any increase in current assets and/or decrease in short-term operating liabilities will result in an increase in a firm’s FNOs; conversely, any decrease in current assets and/or increase in short-term operating liabilities will produce the opposite effect. Current assets mainly consist of customers’ trade receivables, inventory, and cash holdings, while short-term operating liabilities consist of credits from suppliers, employees, and the tax authority. Thus, it is clear that FNOs are closely related to the activity level of the firm.
Companies often allow customers a specified number of days to pay their invoices. The use of such credits generates “trade receivables”, better known as “account receivables”. More specifically, goods or services delivered to customers on credit will increase the receivables balance, and payments subsequently received from customers will decrease this balance. Trade receivables thus show the balance of the current account that customers have with the firm on the balance date.
On average, the balance of a given customer’s current account is obtained by multiplying the daily volume of sales to that customer times the number of days the customer is allowed to take to pay the bill. If we extend this analysis to the whole firm, total account receivables is equal to the firm’s average daily sales (i.e., total annual sales / 360) times the average collection period the firm sets across customers. More formally:
Accounts Receivable = Daily Sales x Collection Period
This equation shows that a firm’s receivables are directly related to the level of the firm’s sales and the number of days the firm allows its customers to take to pay their invoices. This implies that:
- as a firm grows in terms of sales, either because of sustained growth or seasonal growth, FNOs will increase; and
- as the firm increases the collection period offered to its customers, FNOs will again increase.
Before moving on, we note that daily sales are a function of both sales volume and price. Therefore, we can say that:
Accounts Receivable = f (Sales Volume, Sales Price, Days Credit to Customers)
A firm’s inventory is the necessary investment that the firm needs to make to ensure the normal operation of the business and a certain level of customer service. Some firms, because of their operating or commercial structure, need to make a large investment in inventory, while others can operate with a lower level of inventory.
Usually, we can divide a firm’s inventory into raw materials and finished goods. When a company buys a unit of a given input, this is recorded in inventory at the purchase price, while when it produces a unit of a given product and stores it, this item is recorded in inventory according to its cost of goods sold. Firms usually define an optimal number of days to keep each kind of good in their inventory.
The level of a firm’s inventory at any point in time therefore reflects the total value of the goods kept by the firm, as measured by the goods’ appropriate cost. On average, a firm’s inventory balance can be calculated as follows:
Inventory = Daily Cost of Goods x Days in Inventory
Note that this equation masks a number of simplifications and shortcuts; this simple expression is useful in illustrating that a firm’s inventory balance is a direct function of the cost of the goods held in inventory and the number of days that the goods are held in inventory. This implies that as either of these factors increases, FNOs also increase. Similar to the case of receivables, we know that the daily cost of the goods held in inventory is a function of sales volume and the cost of buying or producing each good in question. Thus, we can say:
Inventory = f (Sales Volume, Cost of Goods, Days in Inventory)
Cash holdings are similar to inventory in that, to “keep the company going,” management needs to be sure that the firm has a certain level of cash available to satisfy the cash requirements that arise during normal operations.
Because the need for cash is usually associated with the firm’s activity level and cash cycle, different firms are likely to establish different levels of cash holdings. In general terms, we can define cash holdings as a function of the firm’s activity level, administrative efficiency, and production and cost structure. More formally:
Cash Holdings = f (Activity Level, Efficiency, Production, Cost Structure)
Earlier in this section, we characterized customers’ trade receivables; suppliers’ trade credit works analogously. Suppliers sell their products to the firm and allow a certain amount of time before payment is due. Thus, account payables increases every time the firm receives a new shipment of goods and decreases every time it makes the corresponding payment.
On average, the balance of one supplier’s account is obtained by multiplying the daily volume of purchases from that supplier times the number of days the supplier allows before payment is due. If we extend this analysis to the whole firm, we can define account payables as the firm’s average daily purchases times its average number of days of credit. More formally:
Accounts Payable = Daily Purchase x Days Credit from Suppliers
Obviously, purchases are driven by sales. The determinants of suppliers’ trade credit are thus sales volume, the price of raw materials, and days of credit:
Accounts Payable = f (Units Bought, Price of the Goods, Days of Credit)
As we mentioned, credit from employees and the tax authority add to the spontaneous resources of a firm, reducing the financial needs for operation.
To summarize, any increase in receivables, inventory, or cash holdings or any decrease in credit from suppliers, employees, or the tax authority will increase FNOs (and vice versa). It is worth pointing out, however, that most of these determinants are not always under the firm’s control. For instance, while a firm might set a target level of sales growth, in reality, the firm’s growth will be a function of factors such as the level of growth in the economy, the degree of competition in the market, and the level of advertising in the industry.
Similarly, the ability to influence trade credit terms with customers or suppliers tends to vary over time according to the dynamics of the competitive environment and whether the firm enjoys a strong market power position (i.e., whether the firm is among the few suppliers of a given customer or among the few customers of a given supplier, in which case it would be easier for management to obtain favorable trade credit terms that decrease the firm’s FNOs).
We cannot overstate the importance of the link between a firm’s competitive position and ability to affect the level of FNOs to the dynamics of working capital management. Frequently, errors in corporate strategic and financial planning can be traced to the failure of management to recognize the link between strategy and working capital management. In particular, managers’ assumed levels of FNOs are usually overly optimistic. The upshot is that simple tools, such as Porter’s analysis on the five competitive forces, can help prevent such errors.
Determinants Of Working Capital [A Short Overview]
In contrast to FNOs, a firm strategically sets its level of working capital. To maintain the desired level, the firm will need to adjust its capital structure over time. Notice that the working capital decision implies a choice with respect to the firm’s financing: how much of the firm’s current assets should the firm finance with long-term capital? A great deal of a treasurer’s daily activity and a firm’s future profitability is affected by this decision.
A firm increases (decreases) its working capital when it increases (decreases) its level of equity or long-term debt and/or when it decreases (increases) its level of fixed assets. Therefore, it is crucial to notice that decisions regarding fixed assets and long-term debt and equity are decisions over how to set the appropriate level of working capital. Consequently, working capital should not be considered simply a short-term decision, nor should it be revised or determined solely on a short-term, or operating, basis.
Accounting9 years ago
Check Payment Issues Letter [Email] Templates
Accounting10 years ago
What is Journal Entry For Foreign Currency Transactions
Accounting9 years ago
How To Calculate And Record Depreciation [of Fixed Asset]
Accounting5 years ago
Accounting for Business Acquisition Using Purchase Method