Hi everyone,
Today we’ll go over a new way to think about what a business is.
I’ll share with you a framework that breaks down the idea of a business in its core principles. This will help you enhance your understanding of any company, whether you are an investor, operator, or business owner.
If we break down what a business is in its core components, we can derive four main elements: operations, working capital, financing, investments.
A business is the combination of its operations, working capital, financing, and investments.
Exhibit 1: Core elements of a business
1️⃣ Operations
The operations of a business represent the set of all activities that have to be done to deliver value to customers, generate revenue and cash flows.
This is where the human capital comes into play. Managers and employees have a big impact on the operations of a business, as they perform certain functions such as manufacturing, marketing, accounting, etc.
Michael Porter’s Value Chain framework is a great way to further break down the operations of a business into primary and support activities. Ultimately, these activities influence the company’s overall margins and value creation.
The point is, the operations element is like the engine of the business. Without operations, there is no activity in the business, and therefore no revenues. Operations change over time as the business evolves.
Exhibit 2: Porter’s Value Chain Model
2️⃣ Working Capital
Working capital represents the money (capital) that is tied up in the short term activities of the business.
The accounting definition for working capital is: current assets - current liabilities.
To better understand working capital, think in terms of the resources that are needed in the short-term operations of the business.
Mainly, the operating current assets and liabilities are: accounts receivables, inventory, and accounts payable.
Think about it this way: a business will need capital to operate and execute its daily functions.
For instance:
To sell products, you need inventory. To buy inventory, you need a supplier, which you must pay (cash outflow) in exchange for the inventory.
Once you sell products, you may not instantly receive the cash for it. This will create an accounts receivable, which means that you sold something but haven’t received the cash yet, so can’t use that to fund your operations.
The working capital is an element of its own, because different businesses have different working capital needs.
Some have high working capital needs, while others have negative working capital, meaning that the operations generate some cash that the business can use to fund itself.
3️⃣ Investments
Investments represent the capital expenditures of the business. Capital expenditures are the purchase of long-term physical or fixed assets used in a business’s operations. These purchases are called this way because they are “capitalized” on the balance sheet, and not simply expensed on the income statement.
There are two types of capital expenditures:
Maintenance CapEx
Growth CapEx
Generating sales requires assets, and since assets depreciate over time, businesses must reinvest capital to maintain their assets. Moreover, CapEx is required to grow revenues. Growth is not free - it comes at a high price!
Some businesses are capital intensive, while others are not. You must analyze this element, as it will have a critical impact on the cash flow, and ultimately the value of the business.
4️⃣ Financing
Financing represents the capital structure of the business. Capital structure refers to the amount of debt and/or equity employed by a firm to fund its operations and finance its assets.
Businesses have 3 main sources of capital:
Retained earnings
Debt
Equity
The financing elements is essential, as it is what powers the business. Without financing, a business cannot exist.
Financing with Debt and Equity is not free - free money doesn’t exist in capitalism! Debt has a cost - interest, and equity has a cost - an opportunity cost for investors to give you their money.
A business must manage its capital structure to decrease its cost of capital, and manage its risk profile well.
Exhibit 3: Capital Structure
As an investor, operator or business owner, you must deeply understand these elements and how they ultimately impact the performance and value of a business.
A business is simply a cash-flowing machine. If it doesn’t generate cash, and won’t in the future, then it doesn’t have any real economic value.
To recap, a business is the combination of:
1️⃣ Its operations
2️⃣ Its working capital
3️⃣ Its investments
4️⃣ Its financing
ALL companies operate under these fundamentals. This is like the unifying theory for companies.
With this powerful framework, you are now ready to analyze ANY company.
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Brother let me tell you I just had a better understanding of working capital thanks to this post, what still confuses me is why a negative working capital is positive for the business.
And speaking of business , how could I apply and analyze working capital to a small local business ?
The Following is an actual example:
I have a small local coffee shop in Playa del Carmen (greetings from Mexico ) , so I have no accounts receivable , I owe my coffee and dairy supplier and I have inventory as well but I have no accounts receivable.
That said , how should I analyze and measure working capital ?
Muchas gracias AI !