Many industries are characterized by high seasonality. A seasonal business is one in which the majority of its sales occurs during a short period each year, or a business that experiences substantial changes in trading activity throughout the year. Typical examples of seasonal businesses are those operating in the toy, tourism, and farming industries. For these businesses, it is essential to consider the impact of seasonality on the optimal level of working capital.
Company’s net operating investment (or financial needs for operation) consists of:
- Cash (necessary to more or less cover immediate operating expenses);
- Account receivables or credit to customers; and
And, it is naturally estimated as net of financing obtained from suppliers (i.e., account payables). One might expect the impact of seasonality on a company’s operating activity to be such that, during the seasonal peak, the company will require higher net investment in short-term (current) assets and therefore higher working capital. This intuition, however, is part of the usual confusion.
To see this, let’s consider the case of a company whose main activity is the production and sale of toys (the toy industry is highly seasonal, with most of its sales concentrated between October and December).
What happens to the operating investment of the toy company during its seasonal peak?
To answer this question, let’s look at each of the components of operating investment:
- First, would it have more cash on its balance sheet? Probably yes, since it is likely that the company will face higher costs, such as production and marketing costs, during this time.
- Second, would the company maintain higher levels of inventory in its balance sheet during the high season? Presumably. The timing for the increase in inventory will 28 working capital management depend on whether the company selects a level production plan, which has a stable production rate, or a seasonal production plan, where production follows sales, but in either case average inventory will generally be higher during the peak season.
- Third, would the company show greater account receivables during the peak? Certainly. To help fund this higher operating investment, the company will likely rely on more financing from suppliers.
Nevertheless, the company’s net operating investment is likely to be higher during the peak season.
But does it follow that the company will consequently require higher working capital?
Company’s net operating investments are a short-term financing notion, whereas working capital is mostly connected to long-term finance. This became obvious when we departed from the traditional accounting view of working capital (i.e., current assets minus current liabilities) and defined it as the difference between the permanent resources and the fixed (noncurrent) assets of the company.
Now, let’s use this new perspective to analyze what happens to working capital when the toy company enters its peak season.
Will the manager be likely to finance the company’s higher operating activity by increasing the working capital invested in the company? Well, let’s think!
Will the toy producer issue new long-term debt, or even equity, in order to finance increased activity during these three months?
Considering the related issuance, agency, and information costs, this would probably be an inefficient solution. As a consequence (under the conditions we are exploring right now), the company’s permanent resources will probably remain unchanged throughout the year.
What about the company’s fixed assets (which affect working capital in the opposite direction)? Will our toy producer Current be likely to, say, buy a new truck to adjust her distribution system according to the high season’s requirements?
If she does, she would have to sell it back right after the high season ends to avoid an increase in idle capacity!
So this does not sound like a reasonable strategy either; that is, noncurrent assets are also likely to remain unchanged. So if permanent resources (long-term debt and equity) do not change, and noncurrent assets do not change, working capital, by construction, cannot change.
Seasonality should not affect decisions about the optimal level of working capital. The previous discussion sounds like a proof. However, it does not silence our perceptions, which tell us that something changes during seasonal peaks. If working capital does not change, what does? The answer:
The company’s Firm’s Net Operating Investments!
Next, let’s imagine the summarized accounting information presented next, which corresponds to a period of “low activity“. At the current activity level, the company’s Firm’s Net Operating Investments are equal to $600; that is, it has to look for that amount of funds. Now imagine that the company’s high season arrives, during which time sales are 50% higher; assume operating ratios remain the same.
What will the company’s new Company’s Net Operating Investments be?
When the activity level changes—due, in this case, to a seasonal peak—the financial needs for operation also change; if operating ratios remain constant, they change proportionally.
At this stage, our simple example leads us to the following conclusion:
When a company faces seasonal changes in its trading activity, the company’s working capital should remain the same throughout the year but its Company’s Net Operating Investments should vary with the level of trading activity. In other words, as the company increases its activity level, its Company’s Net Operating Investments should follow the trend; however, because the higher level of activity is expected to last only temporarily, the company has no incentive to change its working capital (which should change as a result of long-term changes in business activity).
Sales = $1,000
Cash = $ 100
Account Receivables = $ 600
Inventory = $ 400
Account Payables = $ 500
Company’s Net Operating Investments = $ 600
+ 50% Growth
Sales = $1,500
Cash = $ 150
Account Receivables = $ 900
Inventory = $ 600
Account Payables = $ 750
Company’s Net Operating Investments = $ 900
We now have the question:
If during its high season the company increases its net operating investment but does not change its long-term financing, how does the company cover the gap?
Following the conceptual path, we should estimate Company’s Net Operating Investments as the difference between current assets and spontaneous resources, but we can also compute them as the sum of short-term debt and working capital. This second expression makes it clear that the necessary net operating investment can be financed in two possible ways: working capital or short-term debt, where working capital is interpreted not simply as an investment decision but also as a financing strategy.
This discussion suggests that when a company faces seasonality, it needs to analyze how to mix alternative sources of funding in order to cover financing needs that vary over time. To deepen our analysis, we now explore alternative financing strategies.
Imagine that the company’s manager wants to minimize raising long-term financing to avoid having to pay associated fees on funds that are not needed during long periods of lower activity. In this case, the manager picks a level of working capital equal to the minimum monthly operating financial need and covers all peaks with short-term financing. During a high season, the company will increase its operating investment and, since working capital does not change, the increased investment will be financed using short-term financial debt. During the low season, in contrast, the company covers all its financial needs with working capital and has zero short-term financing.
Under normal conditions, this strategy could be a cheap one: it minimizes the use of more expensive long-term capital. However, in a more risky or uncertain market environment, this strategy could subject the company to a high level of risk. For example, if, when the company’s financing requirement is high, a credit crunch or a similar crisis makes it impossible to raise short-term financing, this strategy could lead the company to miss out on participating in the hot market and in turn to suffer a considerable loss or even bankruptcy. Additionally, strategies like this one entail high interest rate risk: since the average permanent investment is higher than this minimum level for which the company has chosen long-term finance (i.e., working capital), there would be a mismatch between the average life of the assets and their corresponding financing source.
Now imagine that the manager decides to pursue the opposite strategy. That is, to avoid rushing in search of immediate financing for each peak, she chooses a high level of working capital covered by long-term finance.
Following this second strategy, the manager could sleep very confidently, knowing that all her potential operating financials needs will be covered. However, her comfortable pillow is likely to be extremely expensive, with the company not using its assets to their full potential. During low season, there would be more funds than necessary within the company (i.e., idle funds), which, being long-term loans or even equity, are likely to require a considerable return.
The idle funds could certainly be invested in short-term assets (so that they would be easily available whenever needed), but the return on such investments is generally low, particularly if one compares it with its associated cost. Moreover, this strategy also implies assuming some interest rate risk. Since the duration of assets would be, on average, shorter than the duration of liabilities, interest rate variation would break the balance among them. For example, if the economy enters a recession, leading to lower interest rates, even though the value of both assets and liabilities would increase, the latter would do so more strongly, weakening the financial position of the company.
Which of these strategies is the best one to follow?
The answer probably depends, among other things, on the business’s debt capacity and its access to debt. A company’s location is also likely to influence this decision: if the seasonal company is in the United States, Germany, or similar countries (where financing opportunities are usually relatively easy to access), the optimal choice would probably require a lower investment in working capital (long-term operating finance) than if the same business were located in a developing country (which typically has less deep/liquid financial and capital markets and frequently experiences credit-crunch phenomena). However, in general, the optimal strategy is not likely to be characterized by either of these extreme strategies, but rather is likely to lie somewhere in between.
The sales-off between the goals of minimizing low-return investments (idle cash) and avoiding liquidity risk should guide the proper level of working capital selected. Given this choice, the portion of financial needs for operation that are not covered with working capital will be financed with short-term debt. Thus, while a sound financial policy will count on long-term financing to partially cover varying financial needs, short-term debt should be optimally raised to finance seasonal cash shortages due to changes in operational investment.
When companies fail to have a coherent working capital policy in the context of a developed capital market, a wise advisor would probably point that out and the company would correct the problem, experiencing almost no frictions. When the company instead operates in an emerging economy, usually have low-quality capital markets (i.e., capital is in short supply, market size and liquidity are an issue, and institutional failures are common), inappropriate financing of operating activities can lead the company into financial distress.
Accounting10 years ago
Check Payment Issues Letter [Email] Templates
Accounting10 years ago
What is Journal Entry For Foreign Currency Transactions
Accounting6 years ago
Accounting for Business Acquisition Using Purchase Method
Accounting10 years ago
How To Calculate And Record Depreciation [of Fixed Asset]