Introduction

In this book, we discuss the decision of operating investment and the

corresponding fi nancing, one of the most strategic issues in modern corporate
fi nance. This discussion, mostly ignored by academics until recent
years, becomes extremely important when fi rms expand beyond the
boundaries of effi cient fi nancial markets. Most models in corporate
fi nance understand a fi rm as a set of assets fi nanced by either fi nancial
debt or equity. Even though this standard framework is useful for analyzing
many fi nancial decisions, it might be misleading to guide the crucial
decision of how to defi ne and fi nance the operating investments of a
fi rm.
We focus on these aspects of corporate fi nance by addressing several
important factors. In Chapter 1, we start by presenting the fundamental
framework of corporate fi nance and the basic fi nancial statements generated
by a fi rm. This chapter helps to set the stage, introducing some key
concepts that will be widely used throughout the rest of the book. In the
second and third chapters, we specifi cally address the essential understanding
of working capital management. We start, in Chapter 2, by
explaining the traditional defi nition of working capital and continue by
challenging the standard interpretation and use of the concept. Next, we
provide a more comprehensive framework to think about working capital
management. More specifi cally, we identify the two basic components:

the investment and the fi nancing components. The investment component,

called fi nancial needs for operation (FNOs), represents the operating
investment of the fi rm. The fi nancing component corresponds to the
concept of working capital. In Chapter 3, we study how the size of the
operating investment changes according to the activity level of the fi rm.
Subsequently, we analyze how the fi rm should fi nance this investment
depending on whether it results from growth or permanent change in
trade conditions, or from seasonal variations. It is important to notice
that we constantly shift between investment and fi nancing considerations;
one of the main contributions of this book is precisely the emphasis
on the relevance of this link when analyzing business strategy. In
Chapter 4, we combine the concepts discussed in the fi rst three chapters
to perform a complete fi nancial analysis. We reorganize all the available
information following the traditional ratio analysis and then suggest its
use in an integrated analytical framework.
The next four chapters are dedicated to the study of the main components
of the operating investment of the fi rm: cash, receivables, inventories,
and payables. In Chapter 5, we discuss the reasons why fi rms hold
cash, analyzing some of the traditional cash models in corporate fi nance.
Chapter 6 addresses the main implications of investing in clients’ fi nancing.
It discusses the fi nancing provided to clients, the reasons why fi rms
decide to provide such fi nancing, and the importance of credit risk management.
In Chapter 7, we discuss the importance of inventory management.
Inventories are an important operating decision of the fi rm, with
deep implications in profi tability and fi nancing. Finally, we review the
main theories of inventory management. Last, in Chapter 8, we move to
the other side of the balance sheet and analyze the fi nancing provided by
suppliers. Even if trade credit can be an expensive fi nancing tool, fi rms
still decide to use it extensively. Together, chapters 6 and 8 provide a
review and general discussion of the main theories of trade credit.
Chapter 9 discusses the role of short-term debt in fi nancing the operating
investment. Short-term debt is considered to play a buffer role in
fi nancing the temporary operating investments of the fi rm. Additionally,
the chapter provides a discussion of the main sources of short-term fi nancial
debt.
In chapters 10–12, we emphasize the strategic perspective of
working capital. In Chapter 10, we discuss the role of working capital
management as a strategic tool. We provide an integrated view of
working capital policies, and we discuss how they can be used to help
improve fi rms’ competitive position. Chapter 11 deals with strategic
issues from the fi nancing perspective. It discusses the cost of capital of
the long-term fi nancing of operating assets. Long-term fi nancing, com

posed of long-term debt and equity, has a cost that needs to be considered
by top management in order to make sound fi nancial decisions.
Finally, Chapter 12 discusses some of the observed patterns in working
capital around the world.
This is an important book for general managers who need to understand
the corporate fi nancial framework. Many books and articles discuss
the big corporate fi nancing decisions; the fi nancial impact of day-to-day
business decisions, however, has been frequently ignored. This book aims
at closing that gap. Therefore, this is a book for functional managers who
need to understand the fi nancial consequences of their operating decisions;
this book will show managers (not only fi nancial managers) how
each managerial decision shapes the fi nance position, the cash fl ow, and,
consequently, the profi tability of the fi rm. This text is written, to a large
extent, in a casual and nonformal language so as to make it available to a
wide array of readers. No basic prior knowledge of fi nancial, mathematical,
or statistical concepts is needed to understand the message we intend
to convey.

THE BASIC CORPORATE FINANCE FRAMEWORK

Most businesses are started by an investor who is willing to invest his or
her capital in exchange for a return on the investment. How much of a
return? As fi nancial economists would say, the riskier the investment is,
the higher the expected return.
The money that the investor uses to start the fi rm is referred to as the
fi rm’s initial capital. This money is invested in what is called the fi rm’s
assets, which include everything from the most obvious items such as
property, plant, and equipment, inventory, and cash, to less obvious
items such as customers’ fi nancing. In some cases, especially in the case of
small fi rms, the investor makes all of the fi rm’s investment decisions. In
other cases, particularly as fi rms grow, other people—the fi rm’s management—
are tasked with making these decisions.
Aiming to meet investors’ expected returns, after selecting an optimal
investment the business must use the investment to produce goods
and/or services that will be sold to customers. In generating these sales,
a fi rm will incur several costs, for example, materials and production
costs, storage and distribution costs, employee-related costs, and taxes.
What is left after collecting revenues and paying the related costs is the
fi rm’s profi t, which is the basis for estimating the investors’ return on
investment.

Thus far we have focused attention on “an investor” who decides to

apply his or her money to a given business. In reality, however, most businesses
do not count on a single investor to fi nance the entirety of their
assets; rather, they typically have many investors. These investors are not
all alike. For our purposes here, investors can be characterized according
to the type of contract they establish with the fi rm.
Broadly speaking, we can categorize these contracts into two basic
types: debt contracts and equity contracts . 1 A debt contract is one in which
the fi rm schedules a promised repayment to the investor. The owners of
the corresponding claim are called debt holder s. An equity contract, in
contrast, is a contract in which the fi rm assigns to investors what can be
considered the fi rm’s residual profi t, that is, the profi t that is left over after
the fi rm covers its operating costs and its obligations to debt holders. The
owners of the latter type of claim are named equity holders . Figure 1.1
illustrates this framework.
To summarize, a fi rm’s main business activities consist of identifying
optimal investments, arranging appropriate fi nancing to sustain the
investment, and using the selected investments to generate revenues from
which operating expenses, debt obligations, and equity holders’ returns
are paid. These activities are summarized in a fi rm’s fi nancial statements,
which are the set of documents that collect and organize this information.
We discuss the two most basic fi nancial statements next.

FINANCIAL STATEMENTS
A fi rm’s main business activities as described previously are recorded in
two basic fi nancial statements: (1) the balance sheet and (2) the income
statement. In the following paragraphs, we describe both the primary
characteristics of each fi nancial report taken separately and the interaction
between the two statements. This interaction is important as it
allows analysts to get a more complete picture of a company’s fi nancial
situation and business performance.
The Balance Sheet
The balance sheet provides a snapshot of the fi rm at a given moment in
time. This report has two main parts: the left-hand side, which presents
the assets of the fi rm, and the right-hand side, which shows the corresponding
liabilities . The assets represent the investments made by the
fi rm, whereas the liabilities characterize the way those assets have been
fi nanced. It is easy to see that both parts of the balance sheet refl ect two
sides of the same coin: one cannot be affected without altering the other,
and both have the same size (i.e., the assets are equal to the liabilities). For
example, if we make a new investment, it is either because we have
obtained new fi nancing that allows for it (increasing both assets, refl ecting
the investment, and liabilities, refl ecting the fi nancing), or because
we have funded it with the proceeds of a divestiture of a previous investment
(leaving the total amount of assets and liabilities unchanged).
Similarly, if we obtain new fi nancing, we can accumulate cash or buy
goods or equipment (increasing both assets and liabilities), or we can use
the money to cancel some previous claim (leaving the total fi gures
unchanged).
The items reported on a balance sheet are presented in an order that
follows convention. In particular, assets are organized by liquidity (i.e.,
the ease with which a given asset can be converted into cash), and liabilities
are organized based on exigibility (i.e., when each liability is due). 2
On the asset side, items are sorted by descending liquidity, with the most
liquid assets at the top of the list and the least liquid ones at the bottom. 3
According to this rule, a fi rm’s assets could plausibly be ordered as follows:
cash, bank accounts, marketable securities, trade receivables, inventories,
and, at the very bottom, property, plant, and equipment (PPE).
Note that these assets are grouped into two broad categories: short-term
or current assets, which are expected to become liquid within one year,
and fi xed or noncurrent assets, which are expected to take more than a year
to become liquid. Short-term assets often include items such as cash,
banking accounts, trade receivables, and inventories, and typical noncurrent
assets include PPE and goodwill.
On the liabilities side of the balance sheet, the accounts are classifi ed
based on exigibility, with the most exigible claim (the claim due soonest)
presented at the top and the least exigible claim (the furthest-dated claim)

listed at the bottom. The least exigible claim consists of equity, since equity
holders receive their part after all other obligations have been satisfi ed.
Long-term debt is listed above equity, and before long-term debt are the
different sources of short-term fi nancing. Typically, the fi rst type of obligation
listed is commercial credit, which consists of obligations the fi rm has
with suppliers who sell their goods or services to the fi rm on credit, as such
obligations are usually due within a number of days. Wages and other
obligations due to employees in exchange for labor and managerial services
are often listed next, as such payments are usually made on a monthly
basis, with employees effectively extending short-term credit to the fi rm.
Also included among the short-term liabilities are taxes owed to the government,
which are accrued based on profi t generation but only exigible
on a monthly or quarterly basis, and payments owed on fi nancial debt
such as short-term bank loans or commercial paper.
Figure 1.2 provides an example of a representative fi rm’s balance
sheet.
As we mentioned earlier, the balance sheet provides a snapshot of a
fi rm’s investments and corresponding fi nancing at a given point in time.
One can take such snapshots on a monthly, quarterly, yearly, or other
periodic basis and then compare these snapshots to analyze the evolution
of the fi rm’s investments and fi nancing over time. When analyzing a
fi rm’s investments, we care about not only the size of total investments
but also their main drivers—the inferences we draw about what is happening
to a fi rm that is showing an increase in its trade receivables might
be dramatically different from those we reach about a fi rm that is

observing an increase in inventories. Similarly, when analyzing the evolution

of, say, a growing fi rm’s fi nancing, it is important to look at whether
the growth has been fi nanced with (short- or long-term) debt or equity,
as the fi nancing choice will signifi cantly impact a company’s performance
and risk exposure.
The previous discussion suggests that analysis of a fi rm’s balance sheets
can reveal extremely rich and interesting insights on the fi rm’s performance.
However, in order to have a more complete understanding of the
fi rm’s evolution, we need to have information on what has happened
between consecutive reports. For example, changes in inventory across
balance sheets are linked to how much the fi rm has bought and sold
between report dates, and changes in equity fi nancing are related to the
amount of net income the fi rm has been able to generate. Information on
fi rm activity between balance sheets can be obtained by looking at the
second basic fi nancial statement, the income statement, which is also
called the profi t and loss statement, or the P&L statement for short. One
can think of the income statement as the movie that tells the story of the
company between each pair of balance sheet snapshots .
The Income Statement
The income statement is a representation of a fi rm’s normal business
operations between two consecutive balance sheet statements. In particular,
it records the fi rm’s total sales and costs incurred over the period, from
which the fi rm’s net income (or profi t) is calculated. As is the case for
balance sheets, the income statement can be prepared for any desired
period of time (a week, a month, a quarter, a year, etc.). Typically, a oneyear
interval is used for tax and most legal purposes, but many fi rms also
use quarterly or monthly income statements for different types of supplementary
analysis. Later in the chapter we discuss the various components
of a fi rm’s income statement and then turn to the derivation of net income
(profi t).
The fi rst item reported on an income statement is the fi rm’s total sales,
which is computed by adding all the invoices generated over the period.
It is important to notice that at this stage we do not take into account
whether these invoices have been paid or are still outstanding; we will
consider this distinction in a subsequent chapter. 4
Next, the income statement records the costs of the goods sold over the
period. This item includes, among other things, those expenditures directly
related to producing the goods that have been sold over the period, for
instance, the raw materials used to produce these goods. Note that
expenditures incurred over the period that are related to goods that were
not sold but that are stored as inventory (either as raw material or as

intermediate or fi nal goods) are not counted as costs in the income statement;
instead, these expenditures are recorded as assets, since they are
regarded as an investment that will allow the fi rm to generate future sales.
To illustrate this distinction, consider the case of a fi rm that produces
dining room sets. Assume that in the period under analysis, say a month,
the fi rm produces and sells 5 dining room sets, each using 40 pounds of
wood. The fi rm’s total sales for the month will equal the 5 dining room
sets sold over the month times the price per dining room set sold, and the
fi rm’s cost of goods sold will equal 40 pounds of wood times the cost of
the wood per pound times the 5 dining room sets that have been sold.
No problem so far, as we are making the important assumption that the
fi rm bought the exact amount of wood needed to produce the items sold
over the period. What happens, however, if we relax this assumption?
Imagine now that the fi rm purchased enough wood to produce 10 dining
room sets, but continued to produce and sell only 5 dining room sets. In
this case, the fi rm would show the same total sales and the same cost of
goods sold as before, but would now also show an increase in wood stored
in inventory. The expenditure associated with this surplus wood is
recorded an asset, as this wood will allow the fi rm to produce more dining
room sets to be sold in the future. Note that it does not matter
whether this surplus wood was acquired intentionally as an investment in
future production capabilities or unintentionally as a result of weaker
sales than expected—the accounting implications for the cost of goods
sold and inventory are identical.
Other costs recorded in the income statement include the costs of
keeping the company operational. Some of these costs vary with the level
of production, whereas others are independent of production levels and
are said to be fi xed. Regardless of whether variable or fi xed, these operating
costs are recognized on the basis of their relation with the sales and
other business activity generated during the period, not on the basis of
whether they have been paid during the period. Other fi nancial reports,
as we will see when we turn to sources and uses of funds, concentrate on
actual cash fl ows.
We are now ready to discuss the derivation of a fi rm’s net income. The
fi rst two lines of the income statement present the fi rm’s total sales and
corresponding cost of goods sold (CGS), which includes raw materials,
labor, and variable operating costs. Subtracting CGS from sales gives the
fi rm’s gross margin, which is the income obtained before deducting any
fi xed costs. 5 Subtracting fi xed costs from the gross margin gives earnings
before interest and taxes (EBIT), and subtracting interest expenses from
EBIT yields earnings before taxes (EBT). After deducting taxes, we get
the fi rm’s bottom line, that is, its net income or profi t.