On my post “Overcome Seasonality On Working Capital”, I have addressed the problem of a manager selecting the optimal level of working capital for the case of companies facing seasonality. However, this optimal decision is potentially, indeed, most likely, dynamic: most companies not only observe seasonal variation in economic activity but also grow over time. For example, companies that belong to non-mature industries may experience growth as a part of the natural process, while companies in more mature industries may pursue growing strategies based on market power contests or acquisition plans. Of course, not all businesses experience positive growth—there are businesses that decrease over time, either due to their own decisions or as a consequence of shocks to the economic environment.
The question I turn to here is whether a company should adjust its working capital when it experiences not just seasonality but also a clearly defined trend (either positive growth or negative) in activity level. In this post I address the issue. Follow on…
Let’s think of a company that has been following a growth strategy over the last four or five years. I can imagine that the growth pattern is not even, but rather can be characterized by swings resulting from implementing programs suggested by the company’s various departments. For example, the commercial manager may have suggested that the company encourage sales by giving customers longer payment periods (i.e., by increasing the collection period) at the same time that the operations department recommended increasing inventory (quantity and variety) in order to provide better service.
These measures would effectively increase the amount invested in current assets (specifically, account receivables and inventory), even if the company were supposed to continue operating at the same activity level (certainly, managers are expecting this not to continue to be the case—they are offering strategies precisely to increase sales—but let’s go step by step). Read on…
Imagine a company that, without changing any commercial, production, or operational policy, is experiencing a sudden increase in sales (e.g., consumers started going crazy about one of its key products). Since the investment in, say, receivables will be equal to number of days of customers’ credit daily sales, the company’s operational investment will certainly be higher. However, the impact of growth on operational investment will be stressed if it results not only from an external phenomenon (such as fashion hits or general market growth) but also from the company’s strategic decisions. That is, if the company takes actions that extend its operating ratios (days of receivables or inventory) in order to increase sales, operating investment will grow not only due to simple higher daily volume but also because each dollar of sales requires higher operating investment.
As an example, consider a company that used to allow customers to pay in 15 days, but that has extended the collection period to 20 days, thereby attracting more customers and in turn increasing sales. For each dollar of sales, there would now be five extra days of account receivables waiting to be cashed in. There would also be more sales dollars to finance. This represents a supplementary investment in customers equal to “5 days the previous daily volume + 20 days” the volume increase in daily sales. In this case, both the increase in the collection period and the higher level of sales would require higher investment in current assets, investment that would require additional financing.
Given that the company must increase its investment in current assets to implement its strategic growth policies, the company has to choose between financing this investment with short-term debt or working capital. But how should this decision be made? Is it optimal, as in the case of a seasonal company, to maintain a given level of working capital and cover all additional financing requirements with short-term debt? Let’s explore this option. Read on…
The gap between the financial needs for operation and the corresponding long-term financing (working capital) would increase over time. Therefore, the company would need even greater access to credit (short-term debt), which is not always available—particularly in the case of emerging markets. As a consequence, the company will be able to take advantage of all possible growth opportunities only in those cases in which the current financial market climate makes it possible to access the necessary funds. This is a very risky strategy. Most companies would instead choose a level of working capital that moves in response not to seasonal sales variation, but to a well-defined trend in the level of economic activity.
On the next section, I address an issue when the previous pattern is not applicable; positive Vs negative working capital strategies and growth. Follow on…
Positive Vs Negative Working Capital Strategies And Growth
Earlier, I showed that a pattern of increased sales activity normally requires greater investment in working capital. However, while this is quite intuitive, it is true only under certain assumptions—there are both industries and companies that, based on some particular market condition or corporate strategy, tend to perform differently. I now analyze some cases in which this relation may not apply. Read on…
Consider first the investment in current assets of airlines. These companies’ sales are typically made on the basis of cash or short-term credit card financing; on average, they have a collection period (i.e., account receivables) of less than 15 days. Moreover, outstanding inventory also tends to be low (as is the case for most service businesses); let’s pick a 10-day ratio.
Finally, especially in the case of large airlines, which enjoy market power, suppliers often provide between 20 and 30 days of financing. The Financial Need for Operations [FNOs] of airlines are therefore close to zero or even negative, which implies that these companies are able to pursue a self-financing growth strategy.
Next, consider businesses in which inventory of high turnover or perishable goods is normally delivered at high-frequency intervals (e.g., on a daily basis). The use of automatic replenishment systems, together with the effective exercise of market power, allows these companies to maintain relatively low levels of inventory; let’s pick for our example a holding period of about seven days. What about trade receivables?
Even though some fraction of sales is made on credit, the regular collection period is fairly short, probably less than 10 days. Turning to financing from suppliers, given the volume and consequent market power characterizing some of these businesses (e.g., McDonalds), I can assume a pretty long payment period. Taken together, and considering that these companies will likely have a few days’ cash on hand, I again have a class of companies that are likely to have zero or negative financial needs for operations, that is, companies that are capable of self-financing their growth.
Note that zero or negative financial needs for operations may arise not just from patterns particular to a company’s industry but also from a specific company’s business strategy—a strategy that may even break industry patterns.
A classic example is the case of Dell. Dell’s strategy consists of providing online-based, customized sales, which translates into almost zero inventory and accounts receivable: Dell’s customers place their order on the internet, together with their credit card information; only after payment information has been processed does the company inform its suppliers to start building the required system. This strategy, as has been widely documented, allowed Dell to grow steadily without requiring high investment in working capital.
It is instructive at this point to stop to reflect again on the differences—and complementarities—between financial needs for operations and working capital. In this post so far, I am not focusing attention on companies or industries that are distinguished for simply having negative working capital (although these companies would indeed have negative working capital). Rather, I am pointing out companies that have low required investment in current assets (because of industry patterns or a particular business strategy) and that are likely to rely on significant financing from suppliers experience negative financial needs for operations. Moreover, I am saying that, under these conditions, a company is likely to be able to self-finance its operations and hence would not need to search for financing (be it short-term debt or working capital), regardless of whether the company faces seasonality or pursues steady growth.
Note that in the previous scenario, a company’s working capital will not always be equal to its financial needs for operations. Indeed, this would be the case only if short-term debt were equal to zero.
In contrast, if there is at least some short-term debt, working capital will be larger (in absolute value) than the financial needs for operations. Shifting gears, I now consider a totally different scenario, namely, one in which a company has positive financial needs for operations (i.e., a positive financing gap) and negative working capital. In this case, the company needs to actively finance its operation (i.e., FNOs are greater than zero), and it does so completely with short-term finance.
Note that the short-term finance even covers part of the company’s fixed investment. In general, this is very risky: the company doesn’t simply fail to finance long-term investment with long-term sources of funds (either debt or equity), but it sustains the whole operation (which, as I have observed, is not completely short term in real terms) with short-term financing. What could be potential reasons for doing this?
Perhaps the company has a particular view about future business conditions, or more likely it has no other option (i.e., it faces financing constraints). Indeed, it is often the case in emerging economies that companies are unable to match asset and liability maturities due to market restrictions—they get the financing they can. I will go over these issues next time (Hopefully I can manage my time to post it soon).
The punch line of this analysis is that, while revenues (cash flow) should be financed with short-term debt, profits (growth) should be financed with more permanent sources. Put differently, while seasonality-related sales should be funded primarily through the use of short-term financing, growth should be funded by adjusting the level of working capital—with the exception of companies and/or industries that enjoy low required investment in current assets and high supplier financing, that is, negative financial needs for operations and working capital. This distinction in optimal funding for seasonality and growth should have clear implications for a company’s financial planning.
In particular, failure to differentiate between seasonal fluctuations in economic activity and actual growth will cause the company to either take sub-optimal financing risks (financing with short-term debt investments that really call for long-term financing, resulting in the risk that some opportunities may not receive funding) or pay too high a required return on financial capital (financing short-term needs with long-term debt, resulting in idle funds upon which payments are due).
Accounting9 years ago
Check Payment Issues Letter [Email] Templates
Accounting9 years ago
How To Calculate And Record Depreciation [of Fixed Asset]
Accounting9 years ago
What is Journal Entry For Foreign Currency Transactions
Accounting5 years ago
Accounting for Business Acquisition Using Purchase Method