Need for funds of operations VS. Working Capital, main information you need to know.
NFO (need for funds of operations) = USE OF FUNDS = ASSET (Investment)
NFO are the funds required to finance a company’s operations. You calculate the NFO to know how much credit we will need.
If you operate, you may have to invest money in:
Receivables; since you sell but do not get paid immediately.
Inventories; for future sales
Minimum cash; in some cases you will have to maintain minimum cash or cash necessary for operations. In developed economies, you may assume that the cash necessary for operations is nil.
These 3 items will require financing but, your operations will help you to finance part of these Current Assets since you will have:
Payables (company’s suppliers): you purchase but do not pay immediately. Your suppliers help you to finance your operations.
Spontaneous financing (cost-free): such as deferred taxes, accrued expenses, etc. this are funds that you get for free and that help you to finance your operations.
Therefore,
NFO = Cash necessary + Receivables + Inventory – Payables – Spontaneous financing
If we assume ZERO Cash necessary, and small spontaneous financing then;
[NFO = Receivables + Inventories – Payables]
Be aware that NFO may be changed by middle management.
Example;
A sales representative who decides to give a customer better payment terms = Increase NFO significantly.
Example;
A slowdown in the manufacturing process of company might also increase NFO through an increase in inventories of work in process.
Sometimes an increase in NFO may be more important than an increase in Fixed Assets decided by top management after a thorough deliberation.
The main purpose of the operational finance is to see the financial consequences of operational decisions, or in other words, to calculate the changes in NFO resulting from operational decisions, such as:
Customer credit policy
Payment policy (Depends on the kind of agreement; legal contracts and suppliers)
Inventory policy (operational decisions of the sales department and depends how the market (State of the economy is behaving)
Production process
Etc.
NFO are directly related to sales since all components are related to sales, so:
Growing sales = Growing NFO
Seasonal sales = Seasonal NFO
Two important things have to be taken into account when considering the NFO
Which cash should we use to calculate the NFO? - Cash on the balance sheet - Cash required for operations
When the NFO is taken directly from the balance sheet, it might not be the “Real NFO”* but the “Forced NFO”. Then: - Use the cash required - If the company has credit, use the balance sheet - Ask company for its cash policy
WC (Working Capital) = SOURCE OF FUNDS = Liabilities + Equity
The WC is the Long Term funding available to finance the NFO once the Fixed Assets have been finances (What you have available of permanent resources to finance your operations).
[WC = Equity + Long Term Debt (LTD) – NCA (Non-Current Assets)]
If WC is positive it means that your Equity + LTD > NCA.
HOW TO INTERPRET THE WC?
A high WC means financial stability, it means that you have more finance resources to finance your operations so; [WC > NFO = BETTER]
Example;
So, what’s happening here? In this case, we can clearly identify that when WC is bigger than NFO we have a Cash Surplus (Positive) but when the NFO is bigger than the WC, we need credit (Negative). Therefore, WC > NFO.
*To calculate the Cash Surplus / Credit needed, you just have to do the following; WC – NFO.
*ATTENTION!! WC means more financial stability but not because of the surplus of Current Assets.
CLASSIC DEFINITION OF WC:
The classic definition of WC is [WC = CA – CL or WC = cash + receivables + stocks – payables – other short-term liabilities – credit].
The most typical one that Universities use when teaching is WC = CA – CL but, typically, CA are bigger than CL. Therefore, WC is perceived as an asset, as a CA, according to the “classic definition”.
So, the expression: “Invest in WC” reflects the WC as an Asset. Moreover, WC would change frequently as CA may do.
You may use whatever approach you prefer but, I personally do prefer to see WC as a Source of funds because:
Capital means funding and not investment
The classic definition does not allow you to calculate the credit one needs which, at the end, is the crucial variable in a financial forecast.
The definition can be misleading. If you tell someone to increase the WC and they see the WC as a CA, they may increase receivables and suppliers and that’s not a good option, nobody wants to increase receivables and suppliers.
Also, if you view WC as CA you may think that it changes according to sales and it doesn’t. Example; if you have seasonal sales, WC will still be stable, what will be seasonal is the NFO.
NFO vs. WC
WC < NFO = Need for credit. [NFO = WC + Credit]
WC < NFO = Cash surplus. [NFO + Cash surplus = WC]
If a company needs money, this is because:
There is an INCREASE in NFO
There is a DECREASE in WC
Or, both at same time
The distribution between NFO and WC is essential to diagnose possible company problems:
If WC is scarce, the company has a structural problem
If NFO is in excess, the company has operational problems
Graphic example;
Even so, you will have to analyse 2 types of risks;
Operational Risk: how sensitive is my Net Profit in any economic aspect
Financial risk: variability of my FINEX (Financial Expenses) and if I am able to pay my debt.
Information was gathered from @Tecnocampus and "Finance for Manager from Eduardo Martinez Abascal"
Comments