Financial Analysis Introduction

Financial analysis is related the evaluation of the financial capacity and suitability of a business and potential opportunities. This involves considering types of accounting and various accounting principles with an importance placed on the income statement, balance sheet, and cash flow statement with regard to an overall business and its projects, budgets, and other related transactions. The insights gained from these documents provide an indication of the financial state of a business and areas in which it may be struggling or excelling. In addition, an indication of performance can be calculated based on various metrics with regard to whether the business is stable, solvent, liquid, and profitability, such that these metrics can be compared against other similar businesses or historic performance. From a broad perspective, financial analysis is used to evaluate economic trends, set financial policy, build long-term plans for economic activity, and identify projects for investment. These notes were compiled while completing a basic course on financial analysis.

Accounting Types

Accounting involves collecting, organizing, and analysing financial data and information for businesses and individuals. Accounting is necessary in order to reliably determine the cash flow within a complex business and if the business is profitable and operating optimally. The primary practical aspects of accounting include debits and credits, income statements, balance sheets, cash flow statements, and other financial statements. These aspects are useful in applying further analysis with regard to volumes, liquidity, solvency, valuation, accounting ratios, and forecasts. The areas of accounting range from bookkeeping with the systematic collection of information; financial accounting with a focus on the profit and loss from the income statement, balance sheet, and cash flow statement to form the annual report (available to external stakeholders); managerial accounting with detailed strategic information, such as pricing, marginality, budgeting, and competition (usually only available to internal stakeholders); and tax accounting.

As it is usually the first stage, bookkeeping is essential in order to generate accurate documents in subsequent stages. This implies the fundamental importance of accurately gathering information and maintaining reliable records. As the main output is a set of documents for external stakeholder, financial accounting is also essential, as it is often required to conform to regulations in generating these reports. This provides an overview of the profitability, revenue, expenses, debts, credits, available cash, and other operational metrics. The regulations involved in financial accounting are the Generally Accepted Accounting Principles (GAAP), which are the regulations a business must adhere to when preparing documents in the United States, and International Financial Reporting Standards (IFRS), which are governed by the International Accounting Standard Board (IASB) and recognized by participating countries (including the European Union, United Kingdom, Australia, Canada, Israel, Japan, and South Africa (excludes the United States)).

The income statement focusses on the performance during a period under consideration with regard to the profit or loss. This is usually prepared for an annual period, but it may also be presented on a quarterly basis for larger businesses. The conclusions from the income statement are related to whether economic value was created by the business and can show successive trends in growth, such as revenue growth and gross profit on revenues. The balance sheet focusses on what a business owns and owes for a certain date, such that there is a breakdown of the assets controlled, liabilities outstanding, and equity held by shareholders. It is required for the total assets (left side) to be equal to the sum of total liabilities and equity held by shareholders (right side). The cash flow statement provides an overview of the cash moving into and out of the business during a period under consideration. The avenues of this cash flow are detailed and indicate the liquidity which is generated by the operations of the business. To comply with regulations, these documents must be in an annual report (along with information on history, organization structure, compensation for executives, equity, and subsidiaries).

Income Statement

Revenues are shown on the income statement and represent the inflows of economic resources to the business. For most businesses, the primary source of revenue is conventional sales to customers, but other sources of revenue may include renting resources or selling secondary goods and services. So, the total revenue is equal to the sum of the net sales and other revenue, such that it is possible to separate income coming from core activities and income coming from non-core activities. This can provide an indication of the size of the business and whether it is actually growing compared to previous periods (and how this growth compares to other businesses in the industry).

Expenses are also shown on the income statement and represent the outflows of economic resources from the business. These expenses are usually the costs necessary in order to enable sales and produce the goods and services being sold to customers. The most common types of expenses include the cost of goods sold (goods, services, and salaries of personnel who are involved in production); selling, general, and administrative expenses (advertising, promotions, salaries of personnel who are not involved in production, rent, utility costs, and other costs which are not included in the other types of expenses); depreciation and amortization (using up of tangible assets (property, plant, and equipment) and intangible assets (goodwill, licences, and copyright) until they become obsolete); interest expenses (costs of receiving loans); and taxes (corporate taxes due to authorities). The difference between total revenue and the cost of goods sold is the gross profit (occasionally excludes other revenues). The difference between the gross profit and selling, general, and administrative expenses is an operating profit as earnings before interest, tax, depreciation, and amortization (EBITDA). The difference between the gross profit, selling, general, and administrative expenses and depreciation and amortization is an operating profit as earnings before interest and tax (EBIT). The net income is the difference between total revenue and total expenses. (It should be noted that the profit considered for taxes may be different from the profit required by GAAP or IFRS, as the profit considered for taxes is legislated separately by the government).

The format of an income statement can be single-step or multi-step. A single-step income statement directly calculates the most relevant items consecutively without displaying intermediate or secondary items, such as gross profit or operating income - in other words, the items listed only include the total revenue, total expenses, and net income. A multi-step income statement calculates intermediate or secondary items in addition to the most relevant items, such that gross profits and operating income may be shown. In most cases, a multi-step income statement is produced for a more detailed breakdown. The information for the income statement is sourced from the general ledger and subsidiary ledgers. (In double-entry bookkeeping, revenues (usually related to equity held by shareholders) decrease on the left/debit side and increase on the right/credit side, while expenses (usually related to assets) increase on the left/debit side and decrease on the right/credit side - every transaction has equal and opposite effects in two or more accounts).

Whether prepaid revenues or accrued revenues, revenues can be recognized when there is evidence of an arrangement between the buyer and seller, product has been delivered or service has been rendered, price is determined or is determinable, and seller is reasonably confident of collecting the payment. In this way, revenues are only recognized in the income statement when they are realized or realizable and earned. Similarly, whether prepaid expenses or accrued expenses, expenses can be recognized with a matching principle, such that the expenses are recorded in the same period as the revenues derived from the expenses, or based on the period in which they are incurred if the expenses are not directly related to revenues. In this way, expenses are only recognized in the income statement in relation to their application. It should be emphasized that a revenue or expense becoming realized or realizable and earned does not necessarily align with when cash is transferred, as the cash for the revenue or expense may be transferred before, at the time of, or after incurring the revenue or expense.

The cost of goods sold is directly related to inventory from the balance sheet and is equal to the sum of the product costs for the goods during the period and difference between the inventory at the start of the period and inventory at the end of the period. The product costs are related to the purchase costs for raw materials, personnel costs involved in the production process, overhead costs tied to the production process, and other costs related to bringing the goods to their required location and condition. As product costs can be variable over time, the cost flow method is a mechanism used to decide the cost of the goods which are sold and includes specific identification, first-in first-out, weighted average cost, or last-in first-out. The specific identification involves matching each good sold with its actual purchase costs and is most appropriate when units are not interchangeable; first-in first-out assumes that the first purchase costs match with the first goods sold; weighted average cost determines an average of the purchase costs weighted by the quantity of goods; and last-in first-out assumes that the last purchase costs match with the first goods sold.

With regard to depreciation, the depreciation can usually be calculated based on a straight-line method or activity-based method. The straight-line method considers the initial purchase cost of the asset, its eventual salvage value at the end of its useful life, and length of its useful life and then uniformly divides the difference between the initial purchase cost and salvage value into equal portions over the useful life. The activity-based method tracks the use of the asset based on a usage metric (such as mileage or units produced) with an expected total value at the end of its useful life and then uniformly divides the difference between the current metric and expected total value into equal portions, such that the depreciation is linearly mapped to these portions once they are reached. An identical process can be followed for amortization with intangible assets (as long as the asset has a definite useful life, otherwise it is ineligible as an expense but can still be tested for impairment (value of the asset exceeds the recoverable amount)).

Balance Sheet

The balance sheet gives a breakdown of the assets controlled by a business (left side, debit) compared to the liabilities outstanding by the business and equity held by shareholders (right side, credit). In addition, assets can be divided into current and non-current assets, while liabilities can also be divided into current and non-current liabilities. Current assets or liabilities refer to the short term and items which are fairly liquid (usually less than a year), while non-current assets and liabilities refer to the long term and items which are more illiquid (usually more than a year). For a different perspective on liabilities outstanding by the business and equity held by shareholders, liabilities can be thought of as financing from third parties, while equity held by shareholders can be thought of as internal financing, such that liabilities and equity held by shareholders make up the sources of finance. The information for the balance sheet is sourced from the general ledger and subsidiary ledgers. (In double-entry bookkeeping, assets increase on the left/debit side and decrease on the right/credit side, while liabilities and equity held by shareholders decrease on the left/debit side and increase on the right/credit side - every transaction has equal and opposite effects in two or more accounts).

The primary types of assets include cash or cash-equivalents which provide an indication of the liquidity of the business; accounts receivables or trade receivables which are payments owed to the business by customers from the sale of its goods and services on credit (in other words, the payment has been agreed but has not been received); inventory in the form of raw materials, work-in-progress goods under production, and finished goods which have not been sold; property, plant, and equipment which tend to be illiquid but necessary for production; and other miscellaneous assets. In general, fixed assets are related to long-term assets and can be divided into tangible assets (property, plant, and equipment), intangible assets (goodwill, licences, and copyright), and financial assets (subsidiary businesses and other securities) - with regard to tangible assets and intangible assets, the expenditures on these assets can be capitalized or expensed. For intangible assets, a distinction can be made between assets with a finite useful life, such as software licences, concessions, and sport contracts, and infinite useful life, such as brand names, logos, and websites.

The primary types of liabilities include accounts payables or trade payables which are payments owed by the business to suppliers for raw materials used to produce its goods and services on credit (in other words, the payment has been agreed but has not been sent); financial liabilities due to needing to repay loans which were received and interest on these loans; deferred income taxes which are taxes due to authorities but not immediately payable; obligations to employees, such as pension or retirement benefits which have been agreed; and other miscellaneous liabilities.

Equity held by shareholders refers to ownership claims by shareholders who need to be reimbursed for their ownership, usually through dividends or share repurchases. This is not directly owed to shareholders, as would be the case for a loan, but it is an obligation the business has to its shareholders to fulfil its fiduciary duty, as the business is legally required to act in the best interests of its shareholders. The primary types of equity held by shareholders include paid-in capital which involves capital which has been invested in the business by shareholders; retained earnings as the profits from accumulated earnings in previous years which have not been distributed to shareholders; and net income referring to the profit made in the current year (connected to the income statement).

The recording of transactions on credit within the current period even if the payment for the transactions occurred in an earlier or later period is accrual accounting. This is necessary in order to produce an accurate description of operations in the current period, such that revenues are recorded when they are earned (not when the payment is received) and expenses are recorded when they are incurred (not when the payment is sent). With this, categories of accruals can be formed as prepaid or unearned revenues (payment received before earning), accrued revenues (payment to be received after earning), prepaid or unearned expenses (payment sent before incurring), and accrued expenses (payment to be sent after incurring). Subsequently, prepaid or unearned revenues are recorded as liabilities until they are earned (at which point they will become revenues), accrued revenues are recorded as assets (specifically account receivables until payment is received, at which point they will become another form of asset), prepaid or unearned expenses are recorded as assets until they are incurred (at which point they will become expenses), and accrued expenses are recorded as liabilities (specifically accounts payables until payment is sent, at which point they will become another form of liability).

In most cases, whether a revenue or expense has been earned can be attributed to when the goods or services have been delivered to the customer. In more detail, for revenues, earning can be officially decided when the risks and rewards have been transferred from the seller to buyer, seller has no control over the goods sold, collection of payment is reasonably assured, amount of revenue can be reasonably measured, and costs of earning the revenue can be reasonably measured. In addition, for expenses, earning can be officially decided based on a matching principle, such that the expenses are recorded in the same period as the revenues derived from the expenses, or based on the period in which they are incurred if the expenses are not related to revenues. To maintain certainty, this usually requires a legal contract with payment conditions. Although, as there is a delay in payment, there is still a possibility of default and provisions should be made as a factor of safety based on the uncertainty. It is vital to maintain an objective methodology in determining when a revenue or expense has been earned in order to provide accurate documents without bias or conflicts of interest.

Considering assets and liabilities, it can be difficult to attribute a reliable measurement to their value. This brings into examination whether an asset or liability should be recorded at the historic original price at which it was acquired or at its current fair value market price. For most regulations, it is acceptable to use either the historic original price or current fair value market price, however it is necessary for the business to be consistent in their reporting with the same method applied to all assets and liabilities within the same category and between periods. Typically, the current fair value market price will be used for real estate, brand value, trademarks, debts, pensions, and other fixed assets and liabilities. It should be noted that the estimation of the current fair value market price can be complicated, may require more detail or evidence in the breakdown of the valuation (usually determined by comparing against transactions of similar assets or liabilities in the market), and must be re-evaluated periodically.

It should be noted that accounts receivables may require specific attention if the balance is too large, as this is sub-optimal and potentially unsafe compared to actually having cash. This is due to the possibility of a customer missing or not making the expected payment. If this occurs and especially if too many customers miss or do not make the expected payments, it may affect cash flow requirements, as the business may have debts it needs cash in order to repay. This can be managed through the period of credit allowed for customers to make payments, how those payments are collected from customers, and with a provision for a level of bad debt which will not be repaid. After the period of credit, the business is able to charge interest on the outstanding balance, as agreed upon in the sales contract, but it is possible for the customer to default through bankruptcy. If the customer defaults, it is necessary to use the services of a debt collector and start a legal procedure - it is likely for at least some balance to be recoverable, but it is possible for the entire balance to be irrecoverable. In this case, accounts receivables will be credited with the amount of irrecoverable debt. Additionally, it is possible to use the provision for a level of bad debt which will not be repaid and include this as an expense.

As mentioned, inventory is the portion of assets in the form of raw materials, work-in-progress goods under production, and finished goods which have not been sold. This is directly related to the efficiency at which a customer can receive the goods they have ordered, as the logistics around distribution will depend on whether the goods are in stock or need to be manufactured. However, it can be problematic to have too much inventory, as it may introduce constraints due to the cash flow used to produce the goods which is no longer available (with storage constraints as well). In most cases, merchandisers, wholesalers, and retailers will only hold finished goods to be sold in their warehouses which they source from manufacturers who hold raw materials, work-in-progress goods under production, and finished goods which have not been sold (conversely, businesses with a focus on services will not hold much or any inventory). Inventory is directly related to the cost of goods sold from the income statement.

With regard to liabilities, accounts payables also require specific attention if the balance is too large, as this short-term debt will require cash in order to repay. This requires the sale of goods and services, which were produced from the raw materials received from suppliers, in order to receive cash from customers to pay for the accounts payables which are outstanding. Typically, the period of credit in which the outstanding balance needs to be paid is 30 days, although some cases allow for 180 days with negotiations (usually for consistent and reliable customers). After the period of credit, the supplier is able to charge interest on the outstanding balance, as agreed upon in the sales contract. As a result, there is a need to balance leverage between accounts receivables and accounts payables with negotiations of payment terms. It should also be noted that a transaction is usually denoted as accounts payables when an invoice is issued by the supplier with a delivery receipt, but a transaction is usually denoted as notes payables when a formal contract with payment terms is agreed upon between the business and supplier (conventionally grouped as trade payables).

Generally, the types of financing available to a business are through capital provided by shareholders as equity or capital provided by third-parties as debt. If the capital provided by third-parties is interest bearing, it is classified as a financial liability. This requires a clear distinction between equity and debt in order to accurately represent the financial health of the business, as interest payments decrease net income, while distributions through dividends do not affect income. This distinction can be based on whether the financing contains an obligation to repay the capital in the future, in which case it would be labelled as debt (only if there is no obligation to repay the capital in the future can it be labelled as equity). In addition, a debt covenant can be established with penalties, which sets instructions of behaviour (positive actions, negative prohibitions, or financial health) which the business must follow for the duration of the debt (reduces risk and maximizes chances of repayment). To record a debt, the amortized cost method is usually used, which measures the financial liability at fair value for the period and any transaction costs. To mention, convertible bonds share characteristics of equity and debt, where there is an option for the debt to be converted into equity but still bear interest.

With regard to equity held by shareholders, it is also allowable for a business to accumulate losses from previous periods to offset retained earnings in later periods with regard to tax. If the accumulated losses are greater than the rest of the equity held by shareholders, the business is in technical default and likely requires additional financing from shareholders, otherwise it will inevitably face bankruptcy. As an alternative to retained earnings, treasury stock are shares which have been repurchased by the business from investors and not yet retired - shareholders will see the same result whether retained earnings are distributed as dividends (declaration date, ex-dividend date, holders of record date, and payment date) or treasury stock is retired. This is related to the outstanding shares, which is equal to the difference between the number of shares issued and number of shares reacquired. Other considerations for the equity held by shareholders is the non-controlling interest, which is the pro-rate ownership of equity by minority shareholders, and other comprehensive income, which contains other revenues, costs, gains, and losses excluded from net income.

There are a variety of ways of business can raise equity based on the stage in the lifecycle of the business. This is dependent on whether the business is private, without shares being traded on a public exchange, or public, with shares being traded on a public exchange. The stages in the lifecycle of a business with regard to equity typically begins as a startup with the founders holding the majority of equity from bootstrapping with equity extended to venture capital funds (collected capital from institutions) and business angels (wealthy and private individuals) as the business shows potential. Subsequently, further growth of the business will attract interest for additional financing from private equity funds, after which the business may be able to become publicly traded on an exchange with an initial offering. Once public, it is uncommon for a business to require further financing after becoming public, but it is possible to raise additional capital through a seasoned equity offering with additional shares being issued and sold.

Cash Flow Statement

The distribution of cash coming into and cash going out of a business is detailed on the cash flow statement by tracking the activities in which cash was received or spent. An analysis of the cash flow statement provides an indication of whether a business is liquid and able to avoid insolvency, as it is possible for a business to appear profitable on its income statement but have short-term obligations which impose liquidity constraints. This is related to estimating future capital needs and ensuring the business will receive sufficient cash to satisfy and sustain these needs from its regular operations. The amount of capital being invested in the business is also highlighted on the cash flow statement and indicates whether the business has suitable cash flow to take advantage of new opportunities.

Obviously, the flow of cash is related to the movement of money in a business based on whether the business is receiving or paying cash. This flow of cash will have subsequent implications on other items from the income statement and balance sheet based on the reason why the cash is either flowing into or out of the business. For example, an asset increase is associated with a cash outflow (paid for the asset), asset decrease is associated with a cash inflow (sold the asset), liability increase is associated with a cash inflow (received debt owed to third-parties), and liability decrease is associated with a cash outflow (paid debt owed to third-parties). Similarly, there will be effects on equity when capital is provided by shareholders with a cash inflow or when dividends are distributed to shareholders with a cash outflow.

Typically, the net cash flow for a period can be divided into components for operating activities, financing activities, and investing activities which occurred during the period. These components derive from changes in the items from the income statement and balance sheet. Operating activities usually come from the income statement and are a result of the core business and associated activities affecting the net income. Financing activities usually come from the balance sheet and are a result of transactions which affect the capital structure of the business with regard to both debt and equity held by shareholders. Investing activities usually come from the balance sheet and are a result of investment by the business in fixed assets and other long-term investments. The net cash flow for a period then reconciles with the change in cash between the current period (closing balance) and previous period (opening balance).

The cash flow statement can be represented using the direct method (rarely used) or indirect method (most common) which differ in the way operating activities are presented. Both the direct method and indirect method calculate cash flow from financing activities (such as cash received from obtaining a loan or cash sent for the repayment of the principal of a loan (although it should be noted that the repayment of interest on a loan is listed under operating activities)) and investing activities (such as cash received from investments and cash sent for capital expenditures) in the same way.

The direct method uniformly shows all cash transactions which were made throughout a given period (which aligns with cash accounting, where all transactions are recognized when cash is received or sent, such that net income is equal to cash flow (to be clear, this is not the case for accrual accounting when dealing with accrued revenues and accrued expenses)). Under the direct method, operating activities will include cash received from customers (derived from revenues) and cash sent for suppliers, operations, interest, and taxes (derived from expenses). The indirect method makes adjustment to net income for non-cash transactions which have an impact on net income but do not have an immediate cash effect (which aligns with accrual accounting). Under the indirect method, operating activities will resemble net income or earnings before interest, tax, depreciation, and amortization (EBITDA) with the exclusion of depreciation and amortization, deferred taxes, and other non-cash items (inclusion of only items with a transfer of cash).

To keep in mind, cash has earning potential which creates a time value, where cash in the present is potentially more valuable than cash in the future. With this, the present value of future cash flows can be calculated by assuming a rate at which those future cash flows need to be discounted to be equivalent to cash in the present. This is a more reliable and fair method of evaluating and comparing expected cash flow when the timing of this expected cash flow is relevant. This can also be simplified for common cases, such as when a constant payment is made or received (similar to an annuity).

Financial Statement Analysis

The financial statements of a business can be analysed to determine if the business has sufficient liquidity to repay short-term liabilities (liquidity), if the business is able to manage long-term liabilities (solvency), if the profit earned from the available asset base is satisfactory (profitability), if the business is using its resources efficiently to utilize assets and manage working capital (operating efficiency), if the business has a high level of debt (leverage), and the intrinsic value of the business (valuation). An analysis of financial statements is generally focussed on comparisons against the past performance of the business (trend) and other businesses in the same industry (cross-sectional) in order to understand the health of a business and where it is relative to where it was previously and in relation to similar businesses. To make this comparison, it is common to employ accounting ratios, where ratios of various items are calculated from the financial statements (allows for a relative comparison with percentages, rather than an absolute comparison with magnitudes).

For interest, with regard to investing and when evaluating businesses, projects, budgets, and other financial transactions, fundamental analysis uses accounting ratios and data from financial statements to determine the intrinsic value of a security, where this intrinsic value is compared against the current price of the security. On the other hand, technical analysis assumes that the value of a security is already accurately determined by its price and focuses instead on statistical trends, such as moving averages, in value and price movements of the security over time.

It is possible to calculate days ratios which are measures of efficiency and provide insight into the cash within a business. In essence, the days ratios provide an indication of how long it takes to convert the main working capital components (accounts receivables, accounts payables, and inventory) into cash. The respective ratios are the days of sales outstanding, as the average number of days it takes the business to collect cash from customers after a sale has been recorded (accounts receivables, generated upon selling goods and services on credit); days of payables outstanding, as the average number of days it takes the business to pay cash to suppliers after a purchase has been recorded (accounts payables, generated upon purchasing goods and services on credit); and days of inventory outstanding, as the average number of days it takes the business to convert its inventory into sales (inventory, amount of raw materials, work-in-progress goods under production, and finished goods which have not been sold). Typically, it is preferable for low days of sales outstanding, high days of payables outstanding, and low days of inventory outstanding.

Calculation of days ratios for accounts receivables, accounts payables, and inventory:

\[\begin{gather*} \text{DSO} = \frac{\text{Accounts Receivables}}{\text{Revenue}} \times 360 \\[8px] \text{DPO} = \frac{\text{Accounts Payables}}{\text{COGS}} \times 360 \\[8px] \text{DIO} = \frac{\text{Inventory}}{\text{COGS}} \times 360 \end{gather*}\]

Illustration of the days ratios on a timeline relative to the stages which they include:

As mentioned, accounting ratios allow for an indication of the health of a business with comparison against other similar businesses. With regard to liquidity, the most common accounting ratios include the current ratio, quick ratio, and net trading cycle or cash conversion cycle. With regard to solvency, the most common accounting ratios include the debt ratio, financial leverage ratio, and interest coverage ratio. With regard to profitability, the most common account ratios include the net profit margin, return on assets, and return on equity. With regard to operating efficiency, the most common accounting ratios include the asset turnover, days of sales outstanding, days of payables outstanding, days of inventory outstanding, and net trading cycle or cash conversion cycle. With regard to valuation, the most common accounting ratios include the earnings per share, price-to-earnings ratio, dividend yield, revenue growth, change in sales, change in total assets, and change in net income. Many accounting ratios can be related through manipulation.

Another useful indication of the health of a business is working capital which helps as a gauge of the balance between incomes and expenses for daily operations (comparable to cost of living for individuals). Formally, working capital is equal to the difference between current assets and current liabilities. From this, it is clear that cash flow concerns will arise if working capital is near zero or negative when current liabilities are greater than current assets. In some cases and for a more intuitive understanding, working capital may also be defined as the sum of accounts receivables, inventory, and accounts payables or sum of accounts receivables, inventory, operating cash, and accounts payables.

There needs to be a compromise between both extremes of having too high or too low working capital. If working capital is too high, there may be an opportunity cost due to the excess cash which is not being employed to generate income. Having too high working capital is known as over-capitalization, where the business is missing potential chances to deploy capital for additional growth. If working capital is too low, there may be liquidity issues if unexpected expenses are encountered or cash is not received from customers on time. Having too low working capital is known as over-trading, where the business has insufficient working capital to maintain its current sales. So, there needs to be an inter-related compromise with the most efficient balance between profitability and liquidity, although it can be difficult to fully control working capital due to the dependence on suppliers, customers, and other external factors.

With regard to the management of accounts receivables, it can be useful to pre-screen customers based on their ability to repay debts with a credit terms policy (detailing the risk of default), as this will ensure they are reliable and help in avoiding customers which will default on their debts. This should be enforced with constant monitoring and dedication to the collection of accounts receivables from customers with outstanding debts. With regard to the management of inventory, it is necessary to consider lead time, as the number of days for raw materials to be delivered once an order is placed with suppliers, average daily consumption, as the amount of raw materials used in the production process on a daily basis to create inventory, and safety stock, as the amount of inventory in storage when a new shipment of raw materials arrives (minimum inventory for a margin of error). This can be summarized in the re-order or par level, as the point at which raw materials should be ordered to avoid depleting inventory, which is equal to the sum of the product of lead time and average daily consumption and safety stock. With regard to the management of accounts payables, it can be viewed as a source of financing, as the payment of cash owed to suppliers can be delayed with the cash being used in this period of delay (although, from an ethical perspective, it is vital to respect suppliers and rules of the sales contracts).

It is necessary to employ capital budgeting when considering the implications of investing in a long-term and capital intensive project or asset involving risk. Capital budgeting is associated with determining whether an investment would actually be beneficial and whether it is the most suitable investment relative to alternative options - simply, capital budgeting investigates whether it would be worth investing capital in the present to receive the capital plus an expected return in the future. This involves evaluating the amount of capital needed, timeline for the project or asset, and expected rate of return or internal rate of return. As mentioned, it is required to account for the fact that money has earning potential which creates a time value, where money in the present is potentially more valuable than money in the future.

The primary calculations around capital budgeting are associated with determining the net present value of future cash flows using a discount rate. This discount rate is usually assumed to be equal to or a combination of the cost of debt, as the average interest rate paid for a loan (debt financing from third-parties); cost of equity, as the result of an asset pricing model, such as the capital asset pricing model (equity financing from shareholders); weighted average cost of capital, as a blend of other discount rates based on their proportions, such as the cost of debt and cost of equity; or hurdle rate, as an appropriate rate decided by management. The expected rate of return from the project or asset must be greater than the discount rate in order for the project or asset to be beneficial - in other words, the net present value must be positive in order for the project or asset to be beneficial. The expected rate of return from the project or asset must also be greater than the expected rate of return of alternative options relative to the risk being taken.